Currency Forward

 

What are currency forwards?

A currency forward – also known as an FX forward - is a bilateral over-the-counter (OTC) derivative contract between two parties, typically asset managers or corporates and a liquidity provider. It allows them to lock in the exchange rate for two currencies on a fixed future date.

Currency forwards are primarily used to hedge against adverse currency movements, helping businesses protect profit margins, stabilise cash flow, and forecast future costs or revenues with greater accuracy.

 

How does a currency forward work?

A currency forward locks in today’s exchange rate for a currency transaction to be settled on a future date.

1. Agreeing the contract terms: The business and liquidity provider define the contract terms - currencies, amount, and settlement date.

2. Locking in the exchange rate: The forward exchange rate is agreed upfront, based on the spot rate adjusted for the interest rate differential between the two currencies.

3. Settlement on the agreed date: On the agreed date, the currencies are exchanged at the fixed rate, regardless of prevailing market conditions.

 

Why hedge currency risk with a currency forward?

Currency forwards are a common risk management tool for asset managers and corporates involved in international trade or cross-border operations. By locking in an exchange rate today for a future transaction, these contracts:

• Reduce exposure to currency fluctuations, protecting against adverse moves in exchange rates.
• Provide certainty for budgeting and forecasting, allowing firms to plan with confidence.
• Stabilise cash flows, ensuring that future payments or receipts in foreign currency do not erode profit margins.

In short, currency forwards offer a simple and effective way to manage FX risk, support financial stability, and safeguard performance.

 

Currency forward example

A UK-based business agrees to sell $125,000 worth of products to a US client, with payment due in two months. To protect against the risk of GBP depreciation, the business enters into a forward contract to sell $125,000 at a fixed exchange rate of 1.25 USD/GBP.

Forward contract terms:

• Currency pair: USD/GBP
• Agreed forward rate: 1.25 USD/GBP
• Settlement date: Two months from the agreement date

Settlement calculation:

• Settlement amount: $125,000 ÷ 1.25 = £100,000

By locking in the forward rate, the business ensures that it will receive £100,000 at settlement, regardless of how GBP/USD moves in the meantime.

 

Advantages of currency forwards

Protection from exchange rate fluctuations

Currency forwards help safeguard finances from adverse currency movements that can erode profit margins, especially in volatile markets.

Effective FX risk management

They provide a reliable hedging tool for importers, exporters, and multinational businesses, reducing the risk of unfavourable exchange rate changes.

Improved cash flow forecasting

By locking in future exchange rates, businesses gain certainty over currency costs and revenues, enabling more accurate budgeting and resource allocation.

Customisable contract terms

Forward contracts can be tailored to suit specific needs - including notional amount, settlement date, and contract duration - offering flexibility across different hedging strategies.

 

Disadvantages of currency forwards

OTC traded

Currency forwards are traded OTC rather than on a centralised exchange. While this allows for greater customisation, it also means they can be less liquid and not as easily transferable. Forward contracts cannot usually be cancelled or amended without agreement from both parties, and early termination may incur costs if market rates have moved.

Exposure to counterparty risk

Because forwards are bilateral agreements, there is always a risk that one party may default on their obligation. This exposes the other party to potential financial losses or delayed settlement. Partnering with reputable, tier-one liquidity providers can help mitigate this risk.

Opportunity cost

Forwards lock in a fixed exchange rate, which removes the potential to benefit from favourable currency movements. This can result in missed profit opportunities if the market moves in the hedger’s favour.

Mark-to-Market impact

Depending on accounting standards, currency forwards may need to be marked to market. This can introduce balance sheet volatility even when the underlying exposure is effectively hedged, unless hedge accounting treatment is applied.

 

Currency forward vs FX swap

 

	Currency forward	FX swap
Purpose	Used to hedge future currency exposures by locking in an exchange rate.	Used to manage short-term currency needs and roll or adjust existing FX positions.
Exchange of notional principles	Involves a single exchange of currencies on a future date.	Involves two exchanges: one near-term (usually spot) and one at a future date.
Interest Rate Types	Implied via forward points.	Forward points also reflect interest rate differentials, but no explicit interest payments occur.

 

Currency forward vs FX spot

 

	Currency forward	FX spot
Purpose	Used to hedge future currency exposures by locking in an exchange rate.	Immediate exchange of currencies, typically for settlement within two business days.
Use case	Businesses with forecasted or committed future cash flows.	Immediate currency needs or closing existing exposures.
Hedging instrument	Yes—used for hedging FX risk on future payments or receipts.	No—used for real-time transactions.
Settlement date	Future date agreed upon at contract initiation (e.g. 30, 60, 90 days or custom).	Typically T+2 (two business days from trade date). Some pairs, such as USD/CAD, settle T+1.
Exchange rate	Pre-agreed forward rate, adjusted for interest rate differentials.	Spot market rate at the time of the transaction.
FX pricing	Includes forward points to account for interest rate differentials.	Spot rate with no forward points or time value adjustments.