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What Is an Outright Forward?
Let me explain what an outright forward is. It's a currency contract that locks in the exchange rate and a delivery date beyond the spot value date. This is the simplest type of foreign exchange forward contract, and it protects you as an investor, importer, or exporter from exchange rate fluctuations.
Key Takeaways
- An outright forward, or currency forward, is a currency contract that locks in the exchange rate and a delivery date beyond the spot value date.
- It is the simplest type of foreign exchange forward contract and protects an investor, importer or exporter from exchange rate fluctuations.
- The price of an outright forward is derived from the spot rate plus or minus the forward points calculated from the interest rate differential.
Understanding Outright Forwards
An outright forward contract defines the terms, rate, and delivery date for exchanging one currency for another. If you're a company that buys, sells, or borrows from foreign businesses, you can use these contracts to mitigate your exchange rate risk by locking in a rate that looks favorable to you.
Take this example: Suppose you're an American company buying materials from a French supplier, and you need to pay half the total value in euros now and the other half in six months. You handle the first payment with a spot trade, but to cut down on currency risk from the euro possibly appreciating against the U.S. dollar, you lock in the exchange rate with an outright forward purchase of euros.
The price comes from the spot rate plus or minus the forward points, which are calculated from the interest rate differential. Remember, the forward rate isn't a prediction of where the spot rate will be on the delivery date. If a currency costs more to buy forward than spot, it's at a forward premium; if cheaper, it's at a forward discount.
The spot foreign exchange market usually settles in two business days, except for USD/CAD, which is the next business day. Any contract with a delivery date longer than the spot date is a forward contract. Most are for less than 12 months, but longer ones are possible in liquid pairs. You can also use these for speculating in the currency market.
Settlement
An outright forward is a firm commitment: you take delivery of the currency you purchased and deliver the one you sold. You and the counterparty provide instructions on the specific accounts for currency delivery.
You can close out an outright forward by entering a new contract to do the opposite, which might result in a gain or loss based on market movements. If you close out with the same counterparty, the currency amounts are usually netted under an International Swap Dealers Association agreement. This reduces settlement risk and the amount of money that changes hands.
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