Table of Contents
- What Is a Forward Exchange Contract (FEC)?
- Key Takeaways
- Formula and Calculation of Forward Exchange Contract (FEC)
- Understanding Forward Exchange Contracts (FECs)
- Important Note on Forward Exchange Rates
- Special Considerations
- Forward Exchange Rates
- Example of Forward Exchange Contract (FEC)
- What Is a Currency Forward?
- What Is the Most Actively Traded Currency Pair?
- What Are Blocked and Non-Convertible Currencies?
- The Bottom Line
What Is a Forward Exchange Contract (FEC)?
Let me explain what a forward exchange contract, or FEC, really is. It's an over-the-counter transaction you use to exchange currencies that aren't frequently traded—or sometimes not at all—on the regular forex market. The main goal here is to shield you, the buyer, from those unpredictable swings in currency prices.
With an FEC, you can make exchanges happen even if one or both currencies are blocked or inconvertible in some way. Essentially, it's a straightforward agreement between two parties to swap a pair of currencies at a set time down the line, usually after the spot contract has settled.
Key Takeaways
Remember, an FEC is just an agreement to swap currencies, and it might involve pairs you can't easily get on forex markets. These are traded OTC, so you can customize the terms and conditions to fit your needs. Most importantly, they safeguard both sides from sudden or harmful shifts in future spot rates for those currencies.
Formula and Calculation of Forward Exchange Contract (FEC)
You can calculate the forward exchange rate for one of these contracts using this formula: Forward rate = S x (1 + r(d) x (t ÷ 360)) ÷ (1 + r(f) x (t ÷ 360)). Here, S is the current spot rate of the currency pair, r(d) is the domestic interest rate, r(f) is the foreign one, and t is the contract time in days. That's how you figure it out precisely.
Understanding Forward Exchange Contracts (FECs)
As I mentioned, FECs are OTC deals that let you trade currencies not common in forex, like minor ones or those that are blocked and inconvertible. If it involves a blocked currency, it's called a non-deliverable forward, or NDF.
These aren't traded on exchanges, and they don't use standard amounts. You can't cancel them unless both parties agree. Typically, you're using them to hedge a foreign exchange position or to speculate.
Every FEC includes a currency pair, notional amount, settlement date, and delivery rate. It also specifies using the spot rate on the fixing date to wrap things up. The exchange rate is locked in for that future date, so you can plan your finances accurately. This setup protects you from unexpected drops or rises in spot rates.
Important Note on Forward Exchange Rates
You can usually get forward exchange rates for most pairs up to 12 months out, or even up to five years for the four major pairs.
Special Considerations
The biggest forward exchange markets deal with the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), and Brazilian real (BRL). London has the largest OTC markets, with activity in New York, Singapore, and Hong Kong too. Some places like South Korea have limited onshore forward markets that are restricted.
The U.S. dollar (USD) is the go-to currency in FEC trades. You'll also see active markets with the euro (EUR), Japanese yen (JPY), and to a smaller degree, the British pound (GBP) and Swiss franc (CHF).
Forward Exchange Rates
For most currency pairs, forward rates are available up to 12 months ahead. There are four major pairs: USD/EUR, USD/JPY, USD/GBP, and USD/CHF. You can get rates for these up to 10 years out, and even short contracts of just a few days from many providers.
Keep in mind, though, that to really benefit from an FEC, you probably need a minimum contract amount of $30,000, even if customization is possible.
Example of Forward Exchange Contract (FEC)
Let me walk you through a hypothetical example. Suppose the spot rate for USD/CAD is 1 CAD buys 0.80 USD. The U.S. three-month rate is 0.75%, and Canada's is 0.25%. The three-month forward rate would be: 0.80 x (1 + 0.75% x (90 ÷ 360)) ÷ (1 + 0.25% x (90 ÷ 360)) = 0.80 x (1.0019 ÷ 1.0006) = 0.801. Over 90 days, the rate difference is just one one-hundredth of a cent.
What Is a Currency Forward?
A currency forward is a foreign exchange contract that locks in the rate for buying or selling currency in the future. It's binding because the rate is guaranteed until the set date, and it's traded OTC, not on an exchange.
What Is the Most Actively Traded Currency Pair?
The euro/U.S. dollar (EUR/USD) is the most actively traded pair in forex, making up about 30% of all transactions.
What Are Blocked and Non-Convertible Currencies?
Non-convertible currencies can't be freely swapped for others on forex due to government restrictions. Blocked currencies are funds that can't be transferred out of the country, often applying to otherwise convertible ones held back by regulations. Both are legal in their home countries, but exchanging them elsewhere is nearly impossible. For instance, the North Korean won is non-convertible, and the Indian rupee is partially blocked.
The Bottom Line
In summary, forward exchange contracts are OTC agreements for trading uncommon currency pairs. If you're involved, you're likely after a locked-in rate to guard against sudden value drops in a currency.
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