Forward Contract is a mechanism through which the rate is fixed in advance for purchase or sale of foreign currency at a future date. In such an arrangement, the risk of loss which might accrue on account of adverse movement in the rate of exchange is sought to be removed.
Forward contract can therefore be defined as a firm and binding contract entered into by two parties normally a buyer and a seller, for purchase or sale of specified amount of foreign currency at an agreed rate of exchange for delivery and payment at a future date or during the period agreed upon at the time of entering into the forward deal.
The rate specified in the forward contract is also called forward rate.
The forward rate for a given currency may not necessarily be equal to the ready/spot rate. This is so because the anticipated demand/supply and cost situation on a future date may not be necessarily the same. A currency could be quoted at a higher (premium) or a lower (discount) rate for future deliveries.
In a free market, rates would be based on the demand and supply situation. A currency in excess supply would tend to become cheaper and a scarce one costlier till a balance between the demand and supply is struck.
Besides, given the connection between the exchange rates and funds cost in a totally free market, the premium/discount on forwards would tend to equal the difference in interest rates in the two currencies.
Apart from the interest rate differential there are other factors like the demand and supply situation on a future date, sudden movements of capital, activities of speculators, restrictions on exchange and money market operations, actions of the central banks, etc. that influence forward margins.
Forward rates are generally quoted as a margin (or difference) against the spot rate for the currency concerned. The margin may represent either a premium or discount for reasons explained or the quotation may be at par which means that the forward rate is at the same level i.e. at par with the spot rate.
Quotations of exchange rates (spot or forward) could be either by direct method or indirect method.
In the direct method, the rate is expressed in the form of a given number of units of local currency per unit of foreign currency.
In the indirect method, the rate is expressed in the form of a given number of units of foreign currency per unit of local currency.
The actual outright forward rate is obtained by allowing the forward margin over or under the spot rate. When the forward margin is a premium, it is added to the spot rate to make it dearer while arriving at an outright forward rate. Similarly when the forward margin is at a discount, it is deducted from the spot rate to make it cheaper while arriving at an outright forward rate. This however applies only to rates quoted on a direct basis. The maxims must be reversed when quotations are in the indirect basis.
Forward contracts could be either fixed forward contracts or option forward contracts.
In a fixed forward contract, the transaction will have to be completed on the specified forward date.
If one of the contracting parties is unable at the time of entering into contract to state the exact date on which he will be able to complete the contract he may obtain the consent of the other party to complete the contract on any day during a stated period (i.e. between two specified dates). The person giving the option, in such cases has to quote taking a view that the contract may be completed on the worst possible day from his point of view in order to protect his interest.
A long position in a forward contract implies that the holder has agreed to buy the foreign currency while a short position implies that the holder has agreed to sell it.
The forward contract could either be a deliverable forward contract or a non-deliverable forward contract. In a deliverable forward contract, the actual commitments entered into between the contracting parties will be fulfilled. In non-deliverable forward contract too, the commitments would be fulfilled with a notable feature in which the counterparties settle the difference between the contracted price or rate and the prevailing spot or rate on the settlement day on an agreed notional amount. Non deliverable forward contract is prevalent in countries where forward FX trading is not freely allowed.
A typical forward contract has no secondary market. It is written ‘over the counter’ tailor made to suit the specific exposure requirement. Also the holder of the contract cannot get out of the commitment by simply selling the contract. As the original contract has to be honoured, he can square his position by entering into another contract (reversing the effect of the original contract) to mature on the same day as the original contract. But this is a separate forward contract and does not cancel the first contract.
Hence the effect of a forward purchase contract or a long position in forward contract can be off-set by entering into a forward selling contract or a short position in forward contract matching the original contract in all other aspects.
Normally, forward contracts are built around the principle that the spot and forward rates in the foreign exchange market on the one hand and interest rates in the money market on the other bear certain relationship with each other.
However, this should not be interpreted to mean that forward premium/discount cause interest rate differentials or conversely that interest rate differential cause forward premium/discount.