Forward trading forex

Sometimes, a business needs to do foreign exchange at some time in the future. For instance, it might sell goods in Europe, but will not receive payment for at least 1 year.

How can it price its products without knowing what the foreign exchange rate, or spot price, will be between the United States dollar USD and the Euro EUR 1 year from now?

It can do so by entering into a forward contract that allows it to lock in a specific rate in 1 year. A forward contract is an agreement, usually with a bank, to exchange a specific amount of currencies sometime in the future for a specific rate—the forward exchange rate.

Forward contracts are considered a form of derivative since their value depends on the value of the underlying asset, which in the case of FX forwards is the underlying currencies.

The main reasons for engaging in forward contracts are speculation for profits and hedging to limit risk. However, if the euro declines to equality with the United States dollar by the settlement date, then the company has lost the potential additional profits that it would have earned if it was able to exchange euros for dollars equally.

So a forward contract guarantees certainty — it eliminates potential losses, but also potential profits.

Currency Forward Contracts

So forward futures contracts do not have an explicit cost, since no payments are exchanged at the time the agreement, but they do have an opportunity cost. How is this forward exchange rate calculated?

It cannot depend on the exchange rate 1 year from now because that is not known. What is known is the spot price, or the exchange rate, today, but a forward price cannot simply equal the spot price, because money can be safely invested to earn interest, and, thus, the future value of money is greater than its present value. What seems reasonable is that if the current exchange rate of a quote currency with respect to a base currency equalizes the present value of the currencies, then the forward exchange rate should equalize the future value of the quote currency and the future value of the base currency, because, as we shall see, if it doesn't, then an arbitrage opportunity arises.

Read Currency Quotes first, if you don't know how currency is quoted. For a good introduction, see Present and Future Value of Money, with Formulas and Examples. Using simple annualized interest, this can be represented as:.

If the forward exchange rate equalizes the future values of the base and quote currency, then this can represented in this equation:. The interest rate in Europe is currently 3. Thus, the forward spot rate 1 year from now is equal to 0. The reason why the forward exchange rate is different from the current exchange rate is because the interest rates in the countries of the respective currencies is usually different, thus, the future value of an equivalent amount of 2 currencies will grow at different rates in their country of issue.

The forward exchange rate equalizes the difference in interest rates of the 2 countries. Thus, the forward exchange rate maintains interest rate parity. A corollary is that if the interest rates of the 2 countries are the same, then the forward exchange rate is simply equal to the current exchange rate.

Interest rate parity determines what the forward exchange rate will be. So how can one profit if interest rate parity is not maintained?

As we already noted, if the future values of the currencies are not equalized, then an arbitrage opportunity will exist, allowing an arbitrageur to earn a riskless profit.

Taking the above example of dollars and Euros, we found the forward rate to be 0. But what if the forward rate were only 0. The rest is risk-free profit. This is known as FX spot-forward arbitrage or covered interest arbitrage. Because exchange rates change by the minute, but changes in interest rates occur much less frequently, forward prices , which are sometimes called forward outrights , are usually quoted as the difference in pips — forward points —from the current exchange rate, and, often, not even the sign is used, since it is easily determined by whether the forward price is higher or lower than the spot price.

Since currency in the country with the higher interest rate will grow faster and because interest rate parity must be maintained, it follows that the currency with a higher interest rate will trade at a discount in the FX forward market , and vice versa.

So if the currency is at a discount in the forward market, then you subtract the quoted forward points in pips; otherwise the currency is trading at a premium in the forward market , so you add them.

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In our above example of trading dollars for Euros, the United States has the higher interest rate, so the dollar will be trading at a discount in the forward market. You simply subtract the forward points from whatever the spot price happens to be when you make your transaction.

If the trade is a weekly trade, such as 1,2, or 3 weeks, settlement is on the same day of the week as the forward trade, unless it is a holiday, then settlement is the next business day.

If it is a monthly trade, then the forward settlement is on the same day of the month as the initial trade date, unless it is a holiday. If the next business day is still within the settlement month, then the settlement date is rolled forward to that date. However, if the next good business day is in the next month, then the settlement date is rolled backward, to the last good business day of the settlement month.

The most liquid forward contracts are 1 and 2 week, and the 1,2,3, and 6 month contracts.

Although forward contracts can be done for any time period, any time period that is not liquid is referred to as a broken date.

Some currencies cannot be traded directly, often because the government restricts such trading, such as the Chinese Yuan Renminbi CNY.

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In some cases, a trader may get a forward contract on the currency that does not result in delivery of the currency, but is, instead, cash settled. The trader would sell a forward in a tradable currency in exchange for a forward contract in the tradeless currency. The amount of cash in profit or loss would be determined by the exchange rate at the time of settlement as compared to the forward rate.

You think the price of the Yuan will rise in 6 months to 7. If, in 6 months, the Yuan does rise to 7. The forward exchange rate was simply picked for illustration, and is not based on current interest rates. FX futures are basically standardized forward contracts. Forwards are contracts that are individually negotiated and traded over the counter, whereas futures are standardized contracts trading on organized exchanges.

Most forwards are used for hedging exchange risk and end in the actual delivery of the currency, whereas most positions in futures are closed out before the delivery date, because most futures are bought and sold purely for the potential profit. See Futures - Table of Contents for a good introduction to futures. Example — Covered Interest Arbitrage Borrow: Global Financial Holidays Goodbusinessday.

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