By Frances Coppola
There are four major types of forward contract:
Also called a “European,” “fixed” or “standard” contract, the “closed outright forward” is the simplest type of forward contract.1 In it, the counterparties agree to exchange funds on a specified date in the future (the “value” or “maturity” date). The exchange rate is fixed at the time the transaction is agreed and is typically the spot rate on the transaction date plus a premium or discount known as “forward points,” derived from the interest rate differential between the two currencies.
Closed outright forwards are widely used by businesses to hedge against the risk of losses due to adverse exchange rate movements. However, hedging with closed outright forwards makes it impossible to benefit from advantageous exchange rate movements. Closed outright forwards also offer no flexibility about the date of settlement. Both parties are legally obliged to exchange the funds on the value date. Businesses that need more flexibility over payment terms may prefer open or “flexible” forward contracts.2
In a flexible forward contract, the counterparties can exchange funds on or before the maturity date. The funds can be exchanged in one go (“outright”). Alternatively, several payments may be made over the course of the contract provided that the entire amount is settled by the maturity date. This can give businesses more flexibility in managing their FX cash flow. A window forward is similar to a flexible forward, but exchanges of funds can only be made within an agreed “window” of a few days or weeks.
Forward contracts, whether closed or flexible, are typically for relatively short periods of time such as three months. However, some lock in exchange rates for a year or more. These longer-term contracts are known as “long-dated forwards.” Except for their distant maturity dates, long-dated forwards are similar to shorter-term forwards, though forward points may be larger because locking in an exchange rate for a longer term increases counterparty interest rate risk.
Most forward contracts entered into by businesses involve physical exchange of funds. However, there is a type of forward contract for which the principal benefit is that there is no physical exchange. In a “non-deliverable forward” the counterparties agree to settle only the difference between the contract exchange rate and the spot rate on the maturity date. Settling non-deliverable forwards thus involves only relatively small amounts of money. They are typically used by businesses to hedge currency risk when capital and exchange controls are involved, or when the local currency is not widely traded.3
Forward contracts are traded “over-the-counter,” which means that the contract is between the two counterparties and no intermediary is involved. If one of the counterparties defaults, the other counterparty is left with losses. Forward contracts are also typically not tradeable: if a business needs to back out of a forward contract because conditions have changed, it usually has to do so by entering into an equal and opposite contract with the same maturity. An alternative strategy is to hedge with currency futures.
Currency futures are standardized forward contracts traded on recognized exchanges such as the Chicago Mercantile Exchange (CME). When a business hedges with currency futures, the exchange itself, rather than an individual trader, takes on the business’ exchange rate risk. This can mitigate default risks for the business. However, using futures to hedge FX risk has cash flow implications. Typically, the exchange will require “variation margin” to be posted daily, which is the difference between the cash value of the contract at the agreed exchange rate and the daily spot rate. Daily cash margin calls increase as the exchange rate deviates further from the contract rate.
Some financial instruments with “forward” in their names are actually much more—sophisticated hedging instruments involving financial derivatives, usually options. Hedging with these instruments can enable businesses to benefit to a limited extent from favorable exchange rate movements without losing protection against adverse movements. They are more thoroughly discussed in a five-part series, Explaining Options for Managing FX Risk, From the Basics to the Straps & Straddles. The following three, however, have “forward” in their names, which could lead to confusion.
A participating forward contract combines a vanilla currency option with an outright forward contract. The option premium is reduced or eliminated, but if the option expires out-of-the-money the buyer is obliged to buy a percentage of the funds at a less advantageous “protection rate” rather than at the prevailing spot rate.
A convertible forward contract is a knock-in or knock-out currency option combined with an outright forward contract. The option premium is reduced or eliminated, but the protected exchange rate (outright forward) only applies within a limited range. If the exchange rate moves outside that range, the buyer is no longer protected from exchange rate movements.
A ratio forward combines features of participating and convertible forward contracts. As with a convertible forward, the protected rate only fully applies within an agreed exchange rate range. However, if the exchange rate strays outside that range, the protected rate still applies to an agreed proportion of the funds.
All of these sophisticated hedging instruments can be leveraged. Leveraging increases the potential profit from advantageous exchange rate movements, but it also significantly increases the cost should the limits set in the contracts be breached. Leveraging financial derivatives thus involves taking on additional risk. Businesses may wish to consider the extent to which this is appropriate in their active FX risk management strategy.4
Businesses can deploy different types of forward contract flexibly to meet varying business needs. However, some forward contracts are more sophisticated financial instruments than others. Forward contracts may be best deployed within a considered FX risk management strategy, and may not be suitable for all businesses.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Closed forward contract,” Kantox; https://www.kantox.com/en/glossary/closed-forward-contract/
2. “Open forward contract,” Kantox; https://www.kantox.com/en/glossary/open-forward-contract/
3. “Non-deliverable forward,” Kantox; https://www.investopedia.com/terms/n/ndf.asp
4. “Hedging currency effectively,” World First; https://www.worldfirst.com/app/uploads/2014/03/Hedging-currency-effectively-FCA.pdf