An outright forward, also known as a currency forward, is a type of currency contract used to lock in an exchange rate for a specific delivery date beyond the current spot value date. It is the most straightforward foreign exchange forward contract, providing protection against fluctuations in the exchange rate for investors, importers, and exporters.
Key Insights
- An outright forward locks in an exchange rate and delivery date beyond the spot value date.
- It is the simplest form of foreign exchange forward contract, offering protection against exchange rate volatility for investors, importers, and exporters.
- The price is derived from the spot rate adjusted by forward points, which are calculated using the interest rate differential.
Deep Dive into Outright Forwards
An outright forward contract details the terms, rate, and delivery date required for exchanging one currency for another. Businesses that deal with foreign entities—whether buying, selling, or borrowing—can leverage outright forward contracts to shield themselves from currency exchange risks by locking in a favorable rate.
For instance, suppose an American company is buying supplies from a French vendor. Payment terms might require the American company to pay half the payment in euros immediately and the remaining half in six months. While the immediate payment can be handled with a spot trade, the company can mitigate potential currency risk from the euro appreciating against the U.S. dollar by securing an exchange rate with an outright forward purchase.
The pricing of outright forwards originates from the current spot rate, adjusted by forward points determined by the interest rate differential. It’s important to note that the forward rate is not intended to predict the future spot rate. A currency that trades more expensively on a forward date compared to a spot date is said to be at a forward premium, whereas a cheaper forward date trade is known as a forward discount.
In the spot foreign exchange market, settlements generally occur within two business days, with USD/CAD being an exception, settling the next business day. Any contract longer than the spot date becomes a forward contract. Though most currency forward contracts are usually shorter than 12 months, longer agreements can be made for the most liquid currency pairs. Forward contracts can also be utilized for speculating within the currency market.
Settlement Procedure
An outright forward demands a firm commitment to receive the purchased currency and deliver the currency sold. Each counterparty must provide specific instructions regarding the accounts where they will receive the currencies.
An outright forward can be concluded by initiating a new contract of an opposing nature, which can yield a gain or loss based on market movements compared to the original contract. If this is done with the same counterparty, the currency amounts can often be netted under the terms of an International Swap Dealers Association agreement—this reduces settlement risks and the volume of funds transferred.
Related Terms: exchange rate, delivery date, spot value date, forward contract, currency risk, foreign exchange market.
