A forward exchange contract (FEC) is an over-the-counter (OTC) foreign currency transaction designed to exchange currencies not commonly traded in forex markets. These may include minor currencies as well as blocked or otherwise inconvertible currencies. An FEC involving a blocked currency is known as a non-deliverable forward or NDF.
Broadly speaking, forward contracts are agreements between two parties to exchange a pair of currencies at a specific time in the future. These transactions typically occur after the settlement date of a spot contract and are used to protect the buyer from fluctuations in currency prices.
Key Takeaways
- A forward exchange contract (FEC) allows two parties to conduct a currency transaction, typically involving a currency pair not readily accessible on forex markets.
- FECs are traded OTC with customizable terms and conditions, often referencing illiquid, blocked, or inconvertible currencies.
- FECs act as a hedge against risk, protecting both parties from unexpected or adverse movements in future spot rates.
Understanding Forward Exchange Contracts (FECs)
Forward exchange contracts (FECs) are not traded on exchanges, and standard currency amounts are not traded in these agreements. They can generally only be canceled by mutual agreement between the involved parties.
Parties involved in an FEC usually aim to hedge a foreign exchange position or take a speculative position. All FECs set out the currency pair, notional amount, settlement date, and delivery rate, also stipulating that the prevailing spot rate on the fixing date be used to conclude the transaction.
The contract’s exchange rate is fixed and specified for a future date, allowing the parties to budget efficiently for their financial projects. This protection shields both parties from unexpected or adverse movements in future spot rates. Forward exchange rates for most currency pairs can usually be obtained for up to 12 months in advance, or up to 10 years for the four “major pairs.”
In most cases, even though FEC times can be as short as a few days, the full benefit is often seen when a minimum contract amount of $30,000 is set.
Special Considerations
The largest forward exchange markets are in the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), Brazilian real (BRL), and Russian ruble (RUB). The most active OTC markets are in London, New York, Singapore, and Hong Kong. Countries like South Korea offer limited onshore forward markets alongside an active NDF market.
Most FEC trades are executed against the U.S. dollar (USD). However, there are also active markets for trading using the euro (EUR), Japanese yen (JPY), British pound (GBP), and Swiss franc (CHF).
Forward Exchange Calculation and Example
The forward exchange rate for a contract can be calculated with these variables:
- S = the current spot rate of the currency pair
- r(d) = the domestic currency interest rate
- r(f) = the foreign currency interest rate
- t = time of contract in days
The formula for the forward exchange rate is:
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
Here’s an example: Assume the U.S. dollar (USD) and Canadian dollar (CAD) spot rate is 1 CAD buys $0.80 USD. The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. The three-month USD/CAD FEC rate would thus be calculated as:
Three-month forward rate = 0.80 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360))
= 0.80 x (1.0019 / 1.0006)
= 0.801
The difference due to the rates over 90 days is one one-hundredth of a cent.
Related Terms: Spot Contract, Exchange Rate, Speculative Position, OTC Trading.
