A currency forward is a forward contract whose underlying asset is a foreign currency. A buyer and seller agree today on an exchange rate and the date when the actual transaction will take place, some time in the future. The price of a currency forward is determined by the exchange rate plus the domestic risk free rate. Both the buyer and the seller are obligated to fulfill the contract, even if exchange rates change. Currency forwards are commonly used to hedge currency or exchange risk.
Currency forwards can be thought of as non-standardized currency futures. Their two main differences are that currency forwards are traded over the counter and not in foreign exchanges (forex), and that every element of the forward contract can be tailored. First, the amount and the type of currencies to be bought and sold must be defined. The buyer and seller must also decide on the expiration date when the actual transaction takes place. The contract may be for any amount of time: from a short date forward, which settles in less than three months, to a long date forward, which settles in over a year.
The final specification of a currency forward is the price. Typically the price of a contract is the amount of the exchange plus the domestic risk free rate, which compensates the seller for interest lost from postponing the sale. The difference between the forward price and the spot price is called the forward discount and takes into account the differences between domestic and foreign interest rates. No premiums are required up front, since payment occurs at the expiration date.
Currency forwards differ from other foreign exchange derivatives such as call and put options, since the buyer and seller are obligated to complete the transaction even if the markets have shifted. By purchasing a currency forward, the buyer protects himself against unfavorable exchange rates thus reducing currency risk. Another derivative product that can reduce currency risk is a quantity-adjusting option.
An example of how a currency forward is necessary would be if a United States corporation has commissioned parts which will be ready in six months to be made in France for €100,000 (Euros). The corporation could either buy the euros today, which may not ideally impact the company’s cash flow, or wait six months and hope that the exchange rate hasn’t declined. Otherwise the corporation could buy a currency forward, thus fixing an exchange rate, a forward discount and an expiration date. The corporation is now protected from losing money if the exchange rate declines.