Forward contracts allow for precise pricing for future currency transactions.

FX forwards contracts are agreements to exchange a specified amount of one currency for another at a predetermined exchange rate on a future date and are commonly used to set a precise price for a future currency transaction. For example, hedgers use them as a means to eliminate uncertainty related to pricing for the currency they need to buy or sell at some point in the future.

“Forward Points”: The difference between spot price and forward price

Spot Forex traders are familiar with the effects of interest rate differentials as their positions are credited or debited each day to account for the interest rate differentials of two currencies in a pair. Being long the currency with a higher interest rate results in a credit at the end of each day, while being short the higher interest currency results in a debit to the account. A forward contract’s price is calculated by multiplying the daily credit/debit from today’s date by the number of days until delivery specified by the FX forward contract. The price difference between spot and the forward price is referred to as forward points.

Longer-duration forwards will have larger differentials (more forward points) than shorter-dated forwards to account for the interest rate effect over time.

Calculating a Forward Price Using Spot Price

The spot exchange rate, also known as the current market rate, is the exchange rate for the currencies being traded at the time the contract is initiated. This rate serves as the basis for calculating the forward rate. The price of the forward contract is calculated by determining the value of the interest rate differential between the two currencies and multiplying that difference by the time to expiration of the contract.

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‍How Interest Rate Differentials Between Currencies are Calculated

The interest rates used to determine forward points are based on the base lending rates of the central banks for the currencies being used. For example, if the interest rate for the dollar is 5% and the interest rate for the Mexican peso is 11%, there is a 6% differential. If you want to buy a six-month forward in USDMXN (a hedge against the peso going down against the dollar) you would expect to pay a premium of 3% (6% per year divided by 50% since the duration is six months). This means if the spot rate for USDMXN is 18.00, a six-month forward would be priced at 18.54 (18.00 plus 3% of 18.00). There are many sources available to find current central bank lending rates, including World Interest Rates.

In theory, the forward price should always be calculated strictly on current interest rate differentials. There are times when other factors may be considered when pricing a forward rate. If either (or both) of the countries are expected to change rates during the forward’s life there may be an adjustment in pricing to reflect that anticipated change. There may also be adjustments in pricing due to extreme market volatility. FX forward contracts are custom agreements made by the counterparties, so they can set whatever terms are mutually acceptable.

Strategic Hedging Can Generate Profits as Well as Protection

Most hedges are initiated because of perceived exchange risk. In most cases, the depreciating currency that is being hedged has a lower interest rate than the second currency in the pair. That means that the hedge offers protection with a locked-in rate, but also means that the hedger is benefiting financially from the interest rate differential for the period of the hedge. In the USDMXN example above, the spot rate is 18, but a six-month FX forward contract can be sold short at 18.54. The hedger is collecting the difference. This is the hedging variation of a common speculative strategy referred to as the carry trade.  Of course, if the hedger is going the other way (going long the lower-yield currency), he will have to pay the forward points to enter the transaction. The good news is that forwards are not the only tool that can be used for hedging purposes. Pangea has access to a broad range of financial instruments, such as futures, options, and swaps that can be better alternatives depending on the situation.

FX forward contracts are one of many financial instruments used in currency risk management. Other instruments include futures, swaps, and options. The unique needs of the hedger will determine which product is most suitable, so any hedging program needs to start with a thorough analysis of the risks and desired outcomes.

Schedule a demo with Pangea today to get a risk analysis and discover how you can manage your FX and get the predictability and control you deserve in your business.

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