A forward exchange contract (FEC) is a special type of over-the-counter (OTC) foreign currency (forex) transaction entered into in order to exchange currencies that are not often traded in forex markets. These may include minor currencies as well as blocked or otherwise inconvertible currencies. An FEC involving such a blocked currency is known as a non-deliverable forward, or NDF.
Broadly speaking, forward contracts are contractual agreements between two parties to exchange a pair of currencies at a specific time in the future. These transactions typically take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices.
Forward exchange contracts (FECs) are not traded on exchanges, and standard amounts of currency are not traded in these agreements. Still, they cannot be cancelled except by the mutual agreement of both parties involved.
The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position. All FECs set out the currency pair, notional amount, settlement date, and delivery rate, and also stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction.
The contract’s rate of exchange is thus fixed and specified for a specific date in the future, allowing the parties involved to better budget for future financial projects and know in advance precisely what their income or costs from the transaction will be at the specified future date. The nature of FECs protects both parties from unexpected or adverse movements in the currencies’ future spot rates.
A forward exchange contract is an agreement under which a business agrees to buy a certain amount of foreign currency on a specific future date. The purchase is made at a predetermined exchange rate. By entering into this contract, the buyer can protect itself from subsequent fluctuations in a foreign currency’s exchange rate. The intent of this contract is to hedge a foreign exchange position in order to avoid a loss, or to speculate on future changes in an exchange rate in order to generate a gain.
Forward exchange rates can be obtained for twelve months into the future; quotes for major currency pairs (such as dollars and euros) can be obtained for as much as five to ten years in the future.
The exchange rate is comprised of the spot price of the currency, the bank’s transaction fee, and an adjustment (up or down) for the interest rate differential between the two currencies. In essence, the currency of the country having a lower interest rate will trade at a premium, while the currency of the country having a higher interest rate will trade at a discount. For example, if the domestic interest rate is lower than the rate in the other country, the bank acting as the counterparty adds points to the spot rate, which increases the cost of the foreign currency in the forward contract.
Fixed and option forward contracts, Calculation of fixed and option forward rates
Under the fixed forward contract, the delivery of foreign exchange should take place on a specified future date. Then it is known as ‘fixed forward contract’. Suppose a customer enters into a three months forward contract on 5th January with his bank to sell Euro 15,000, then the customer would be presenting a bill or any other instrument on 7th April to the bank for Euro 15,000. The delivery of foreign exchange cannot take place prior to or later than the determined date.
Though forward exchange is a mechanism wherein the customer tries to overcome the exchange risk, the purpose will be defeated if the delivery of foreign exchange does not take place exactly on the due date. Practically speaking, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents for reasons which are internal relating to production. Besides internal factors relating to production many other external factors also decide the date on which he is able to complete shipment and present documents to the bank. More often, what is possible for the exporter is only estimate the probable date around which he would be able to complete his commitment.
Under such circumstances, just to avoid the difficulty of fixing the exact date for delivery of foreign exchange, the customer may be given a choice of delivering the foreign exchange, during a given period of days. Such an arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as ‘Option Forward Contract’. The rate at which the deal takes place is the option forward rate. For example, on 10th June a customer enters into two months forward sale contract with the bank with option over August. It means the customer can sell foreign exchange to the bank on any day between 1st August and 31st August In the example, the period during which the transaction takes place is known as the ‘Option Period’.
Forward Price Formula
The forward price formula (which assumes zero dividends) is seen below:
F = S0 x erT
F = The contract’s forward price
S0 = The underlying asset’s current spot price
e = The mathematical irrational constant approximated by 2.7183
r = The risk-free rate that applies to the life of the forward contract
T = The delivery date in years
Inter Bank Deals
The interbank market is a global network utilized by financial institutions to trade currencies and other currency derivatives directly between themselves. While some interbank trading is done by banks on behalf of large customers, most interbank trading is proprietary, meaning that it takes place on behalf of the banks’ own accounts. Banks use the interbank market to manage their own exchange rate and interest rate risk as well as to take speculative positions based on research.
The interbank market is a subset of the interdealer market, which is an over-the-counter (OTC) venue where financial institutions can trade a variety of asset classes among one another and on behalf of their clients, often facilitated by interdealer brokers (IDBs).
The interbank market for foreign exchange (forex) serves commercial turnover of currency investments as well as a large amount of speculative, short-term currency trading. The typical maturity term for transactions in the interbank market is overnight or six months.
The forex interdealer market is characterized by large transaction sizes and tight bid-ask spreads. Currency transactions in the interbank market can either be speculative (initiated with the sole intention of profiting from a currency move) or for the purposes of hedging currency exposure. It may also be proprietary but to a lesser extent customer-driven by an institution’s corporate clients, such as exporters and importers, for example.