Definition of a Forward Contract
Forward Contract is an agreement between two parties (usually between two financial institutions or between a financial institution and one of its clients) to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate. It increases credit risk for both parties.
Forward Rates = spot rate +/- premium/discount
Forward Market Consists of
Arbitrageurs: Arbitrageurs sell and buy the same currency to profit from exchange rate discrepancies within a market centre or across market centers.
Role of different factors in Arbitrage market
- Is cross rates differ from one financial center to another, and profit opportunities exist?
- Buy cheap in one market, sell at a higher price in another
- Available Information in the market
Traders – Traders use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currency.
Hedgers –Hedgers, engage in forward contracts to protect the home currency value of various foreign currency denominated assets & liabilities on their balance sheet that are not to be realized over the life of the contract.
Speculators Buying & sellingcurrencies forward in order to profit from exchange rate fluctuations. It is based on prevailing forward rates & their expectations for spot exchange rates in the future.
Forward contracts ability to lock in a purchase or sale price without incurring much direct cost makes it attractive for hedging as well as speculation.
Forward Rate Quotations
Outright Rate: quoted the actual price to commercial customers.
Swap Rate: quoted in the interbank market as a discount or premium, on the spot rate. This forward differential is known as swap rate.
Forward Contract Maturities
Contract Terms 30-day, 90-day, 180-day, 360-day
Longer-term Contracts usually be arranged for widely traded currencies, such as US Dollar, Deutsche mark, or Japanese yen.