Currency Forward Contracts

A currency forward contract is an agreement to exchange a specified amount of one currency for another on a future date at a rate fixed today. By locking the forward exchange rate, it converts an uncertain future domestic-currency payment or receipt into a predictable amount.

How the hedge works

The participant takes a forward position opposite to the risk created by the underlying transaction. The contract's amount, currency and maturity are matched as closely as possible with the expected payment or receipt.

• An importer expecting to pay foreign currency buys it forward; a later depreciation of the rupee therefore does not increase the locked rupee cost.
• An exporter expecting foreign-currency receipts sells them forward; a later appreciation of the rupee therefore does not reduce the locked rupee proceeds.
• A borrower with foreign-currency debt can buy currency forward to make future interest or principal payments more predictable.

Pricing and settlement

The forward rate is agreed when the contract is entered into. It is linked to the spot rate and the interest-rate differential between the two currencies, rather than being merely a forecast of the future spot rate.

• On maturity, the currencies may be delivered at the contracted rate, or the contract may be settled according to the applicable settlement terms.
• The gain or loss on the forward offsets, wholly or partly, the adverse change in the domestic-currency value of the underlying exposure.

Protection and limitations

A forward protects against adverse exchange-rate movements by providing certainty, but it does not guarantee the most favourable outcome.

• If the exchange rate moves favourably, the participant generally forgoes that benefit because the contracted rate remains binding.
• An imperfect match of amount or maturity creates residual exposure, while cancellation or rollover can impose costs.
• As an over-the-counter contract, a forward also involves counterparty credit risk; using it without an underlying exposure can create speculative risk.

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