The post Currency Forward Defined by Jay and Julie Hawk appeared first on Benzinga. Visit Benzinga to get more great content like this.
Many corporations and some high-net-worth individuals use currency forward contracts to hedge their future or forward currency exposures to the forex market against unfavorable moves. Companies with international currency risk typically hedge to help stabilize the domestic value of their foreign currency cash flows or investments.
Forward contracts trade in the over-the-counter forex market rather than on an exchange. Other names for a currency forward contract include a forward outright and an FX forward.
If you’re interested in finding out more about currency forward contracts, then read on.
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What is a Currency Forward?
In the forex market, a currency forward or forward outright contract involves a binding agreement between two counterparties where one agrees to buy and the other to sell a set amount of one currency versus another at an agreed-upon rate of exchange or “exchange rate” for delivery on a future delivery date that is generally different from the current spot value date.
FX forwards trade in the over-the-counter or OTC forex market, so their terms can be customized. For example, a counterparty can select a currency pair, a notional amount and/or a delivery date for the contract that suits their particular needs.
The forward rate for a particular currency pair and value date depends on the prevailing spot rate, the length of time until delivery and the interest rate differential between the two currencies involved.
How Does a Currency Forward Work?
Currency forward contracts generally settle on a day beyond or forward of the current spot value date. A forward contract’s forward outright exchange rate must therefore take into account the interest rate differential between the two currencies. This requires knowing the Interbank deposit interest rates for each currency pertaining to the value date of the forward contract.
Unless those deposit interest rates are the same for each currency, the interest rate differential will benefit the counterparty holding the higher interest rate currency over the term of the forward contract.
The counterparty holding the currency with the lower interest rate must compensate the other party to the currency forward contract by paying the difference between the interest rates over the duration of the contract. This difference and the prevailing spot exchange rate are fed into a standard formula to derive the FX forward outright’s exchange rate.
The difference in pips between the spot and forward outright exchange rates is known as swap points. These swap points are quoted by forex forward desks to their clients so that the swap points can be easily added to or subtracted from the prevailing spot rate, as appropriate, to compute the forward outright rate.
How Do You Calculate a Forward Rate?
You can determine the forward outright rate for a currency forward contract for a given value date using this formula:
F= S[(1 + ib)/ (1 + ic)]
Where:
F = the forward outright rate for the currency pair
S = the spot exchange rate for the same pair
Ib = the base currency Interbank deposit interest rate for the given future value date
ic = the counter currency Interbank deposit interest rate for the given future value date
However, since the delivery date of a currency forward is often not an entire year in the future and Interbank deposit interest rate quotes are generally annualized, you will usually need to convert those annualized rates to fractional year interest rates to use the equation above. You can do that conversion using this formula:
if = ia x (Dv/Dy)
Where:
if = fractional year interest rate
ia = annualized interest rate
Dv = the number of days until the forward contracts’ value date
Dy = the number of days in a year
If you want to determine the swap points that apply to a particular value date for a currency pair, you need to compute the difference in pips between F (the forward outright rate that was computed in the preceding equation) and S (the prevailing spot rate for the currency pair). You can use this formula to do that:
Swap points= F – S
Once you know or are quoted the swap points for a given value date, you can readily calculate the forward rate for delivery on that date given a spot rate quote. If you are a client to a market maker, then remember that you will be buying (selling) the base currency outright at the offer (bid) side of the quoted spot rate and swap points.
What is the Difference Between Currency Forwards and Currency Futures?
The main difference between currency forwards and currency futures is that forwards are customizable and trade in the OTC forex market while currency futures trade on exchanges like the Chicago Mercantile Exchange (now part of the CME Group) and are standardized in terms of their notional amount and value dates.
Example of a Forward in Forex Trading
In practice, forwards are generally transacted by trading the desired notional amount for value spot after first getting a quotation for the swap points from a forward desk for the desired forward value date. The spot position is then rolled out to the forward date and the exchange rate is adjusted by the quoted number of swap points.
For example, forwards are often used by corporations looking to hedge a known foreign currency exposure against adverse exchange rate movements. The best type of forex exposures to hedge with a currency forward are known in their amount and their date. Forwards can be transacted in custom amounts and value dates running out to 10 years.
As an example of how a forward might be used, consider the situation of a Canadian corporation that has signed a contract in U.S. dollars for goods from a U.S.-based supplier. The terms of the contract specify that they will need to pay $10 million U.S. dollars to the supplier in three months’ time.
To protect against adverse moves in the USD/CAD exchange rate, the corporation’s financial department decides to execute a forward transaction to buy the $10 million with Canadian dollars in advance and roll it out for three months so that it can be delivered per the contract.
They call up a commercial bank they have a good relationship with and ask for an offer on a three-month USD/CAD currency forward in $10 million. The bank’s USD/CAD forex dealer quotes the offer side for the USD/CAD spot exchange rate of 1.3200, and the bank’s forward desk quotes the offer side for the three-month swap points of 5 pips or 0.0005 for that amount.
If transacted at those quotes, the all-in exchange rate for the three-month forward the Canadian corporation needs would be (1.3200 + 0.0005) = 1.3205.
Note that since the Canadian dollar currently pays a higher rate of interest rate than the U.S. dollar, the Canadian dollar trades at a forward discount to the U.S. dollar. Also, because the forward rate is just computed based on the current deposit interest rate differential pertaining to the forward value date, it does not incorporate a market view regarding the future level of the USD/CAD exchange rate on that date.
Forex Forwards and Hedging
The example in the previous section uses a very common FX forward hedging scenario to illustrate how a corporation might use a forex forward to hedge against a known future forex exposure.
This is one of the most popular applications of forex forwards, and corporations engaged in the international trade of goods and in offering services to foreign companies often use forwards to hedge their known foreign currency exposures in this manner.
Furthermore, international companies often have foreign offices or subsidiaries that incur substantial operating costs. The budgeted amounts of these foreign costs are often hedged in advance by the head office once they are projected by management.
This prudent hedging practice allows a company’s head office to buy the projected necessary amount of foreign currency with its domestic currency in advance to pay in foreign currency for the projected operating expenses that its foreign operations will need in the future.
Trade Forwards with These Top Forex Brokers
Benzinga has helped take the guesswork out of finding a reputable online forex broker by compiling the following table of top forex brokers.
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get started
securely through FOREX.com’s
website
FOREX.com is a one-stop shop for forex traders. With a massive range of tradable currencies, low account minimums and an impressive trading platform, FOREX.com is an excellent choice for brokers searching for a home base for their currency trading. New traders and seasoned veterans alike will love FOREX.com’s extensive education and research center that provides free, informative forex trading courses at multiple skill levels. While FOREX.com is impressive, remember that it isn’t a standard broker.
Best For
- MetaTrader 4 users
- Beginner forex traders
- Active forex traders
- Impressive, easy-to-navigate platform
- Wide range of education and research tools
- Access to over 80 currencies to buy and sell
- Leverage available up to 50:1
- Cannot buy and sell other securities (like stocks and bonds)
get started
securely through CedarFX’s
website
Billing itself as the world’s 1st eco-friendly broker, CedarFX makes it easy to trade and give back to the planet. You can choose a 0% Commission Account or an Eco Account — or open multiple accounts to meet all your needs.
CedarFX offers access to a wide range of tradable securities, including stocks, futures, major and exotic forex pairs, cryptocurrencies and more. Though CedarFX could introduce a few additional educational resources, the broker remains a unique option for traders invested in giving back.
Best For
- Forex investors
- Investors interested in 0% commission or eco conscious trading
- Investors looking for 24/7 customer service
- Allows users to offset their carbon footprint
- 0% commission investing
- Offers demo account access
- 24/7 customer service available through live chat
- Eco Account Option (10 trees planted for each lot traded)
- Fast deposits/withdrawls with Bitcoin
- Limited number of educational resources for new investors
get started
securely through IG Markets’s
website
IG is a comprehensive forex broker that offers full access to the currency market and support for over 80 currency pairs. The broker only offers forex trading to its U.S.-based customers, the brokerage does it spectacularly well. Novice traders will love IG’s intuitive mobile and desktop platforms, while advanced traders will revel in the platform’s selection of indicators and charting tools. Though IG could work on its customer service and fees, the broker is an asset to new forex traders and those who prefer a more streamlined interface.
Best For
- New forex traders who are still learning the ropes
- Traders who prefer a simple, clean interface
- Forex traders who trade primarily on a tablet
- Easy-to-navigate platform is easy for beginners to master
- Mobile and tablet platforms offer full functionality of the desktop version
- Margin rates are easy to understand and affordable
- Access to over 80 currency pairs
- U.S. traders can currently only trade forex
- Customer service options are lacking
- No 2-factor authentication on mobile
Get started
securely through AvaTrade’s
website
A fully regulated broker with a presence in Europe, South Africa, the Middle East, British Virgin Islands, Australia and Japan, Avatrade deals with mainly forex and CFDs on stocks, commodities, indexes, forex, cryptocurrencies, etc. This brokerage is headquartered in Dublin, Ireland and began offering its services in 2006. It offers multiple trading platforms and earns mainly through spreads.
Best For
- Beginners
- Advanced traders
- Traders looking for a well-diversified portfolio
- Controlled by regulatory agencies of multiple countries
- Choice offered in terms of trading platforms
- Support available in 14 languages and trading platforms in 20 languages
- Practice/demo account available for trying out
- Breadth of trading assets
- Does not accept customers from the U.S. as it isn’t regulated in the U.S.
- Transferring funds to the account may take up to five days; withdrawals could take up to 10 days
Get started
securely through Pepperstone’s
website
Pepperstone is an Australian broker focused on providing international forex, CFD and cryptocurrency trading. Though U.S. traders currently cannot open an account with Pepperstone, the broker remains an affordable and comprehensive option for international traders.
Pepperstone offers traders access to over 61 forex markets, over 60 CFDs for index funds and stocks and 5 cryptocurrencies. Leverage options with Pepperstone are extensive; you may qualify for up to 500:1 leverage when trading currencies and up to 5:1 leverage when trading cryptocurrencies, for example.
There are a few areas where Pepperstone can afford to improve. We’d love to see Pepperstone add its own trading platform in the future instead of relying entirely on 3rd-party platforms. We’d also love to see direct stock and fund purchase options in the future. Despite these flaws, Pepperstone remains a very strong choice for international traders.
Best For
- International traders interested in trading CFDs from foreign markets and currencies
- Traders who are already familiar with the MetaTrader or cTrader platforms
- Traders who are looking for leverage when trading cryptocurrencies
- Access to over 61 forex pairs and over 60 stock CFDs
- Leverage available for both forex and cryptocurrency trading
- Wide range of educational tools and courses that both beginners and experts can use
- 24/7 customer service
- Not currently available to U.S. traders
- No option to purchase stocks, bonds or mutual funds directly; only CFDs are available
Get started
securely through HYCM’s
website
HYCM is 1 of the world’s leading forex brokers, offering investors access to over 69 unique currency pairs. However, forex isn’t the only thing the broker offers — HYCM also offers high rates of leverage, stock and ETF trading, commodity investing and much more. Getting started with HYCM is quick and easy, and most investors can open an account in as little as 10 minutes.
HYCM offers a varying fee structure, which allows investors to choose the spread option that’s best for them. A wide range of educational and investing tools are available, which can be equally beneficial to both experienced and novice traders. Though HYCM isn’t currently available in the United States, it can be a great choice for residents of the other 140 countries where it offers service.
Best For
- Investors who want a customizable fee schedule
- Traders comfortable using the MetaTrader platform
- Islamic traders who need swap-free accounts that don’t build interest
- Wide range of currency pairs available
- Excellent selection of educational tools
- $0 deposit and withdrawal fees
- Not currently available to traders based in the U.S.
get started
securely through SimpleFX’s
website
SimpleFX is a cutting-edge online trading app, allowing you to invest fiat money or cryptocurrency in forex, crypto, indices, precious metals and commodities. With the WebTrader, you can learn to invest online and unlock advanced features designed for your success.
Best For
- Traders who need lots of options
- Customers who wish to invest with leverage
- Multicurrency traders
- Cryptocurrency owners who would like to invest with them
- Traders who prefer to skip the KYC and sign up just with an email address
- Experienced traders who would like to use MT4
- Simple to manage
- 60 currency pairs
- Spreads as low as 0.1
- Trading never closes
- Stock trading
- No minimum deposit
- No KYC for cryptocurrency accounts
- On the market since 2014
- Almost too many options for new investors
- Not yet available to U.S. users
get started
securely through eToro’s
website
Though Australian and British traders might know eToro for its easy stock and mobile trading, the broker is now expanding into the United States with cryptocurrency trading. U.S. traders can begin buying and selling both major cryptocurrencies (like Bitcoin and Ethereum) as well as smaller names (like Tron Coin and Stellar Lumens).
eToro offers traders the opportunity to invest their assets into premade portfolios or cryptocurrencies, similar to services offered by robo-advisors through traditional brokers. Though eToro isn’t a one-stop-shop for everything an investor needs, its easy-to-use platform and low spreads is a great way to enter the cryptocurrency market.
Best For
- International Forex/CFD Traders
- New cryptocurrency traders looking for an easy-to-use platform
- Traders who want to buy and sell cryptocurrencies on-the-go
- Simple platform that is easy to master
- CopyTrader feature that allows new traders to copy the same strategies used by professionals
- Virtual dummy account that gives you $100,000 to practice trades
- U.S. traders currently limited to cryptocurrencies
- Only 15 major coins available to trade
Frequently Asked Questions
Can you sell a currency forward?
Yes, you can sell one currency in exchange for another currency for a value date in the future if you can trade in the over-the-counter forex market.
Answer Link
Is a currency forward a security?
No, a currency forward is instead an over-the-counter contract traded in the forex market that allows you to lock in an exchange rate for a future delivery date.
Answer Link
Are forward contracts risky?
Yes. They are about as risky as a spot transaction with respect to the resulting exposure to exchange rate fluctuations. Forward contracts can also be used to hedge existing forex exposures.
Answer Link
The post Currency Forward Defined by Jay and Julie Hawk appeared first on Benzinga. Visit Benzinga to get more great content like this.
