What is a FX Forward?

A foreign exchange (FX) forward is a financial contract in which two parties agree to exchange a specified amount of one currency for another at a future date, based on a predetermined exchange rate. It is a type of derivative used to hedge against currency risk or speculate on future movements in exchange rates.

Here’s a closer look at the key elements of an FX forward:

1. Future Date: The contract specifies a future date (the maturity date) when the exchange will occur. This could range from a few days to several years into the future.

2. Pre-Determined Rate: The exchange rate agreed upon today (the forward rate) is fixed and will be used for the currency exchange on the contract's maturity date. This rate is different from the current spot rate and is influenced by factors such as interest rate differentials between the two currencies.

3. Contract Size: The contract specifies the amount of each currency to be exchanged. The size of the contract can vary based on the needs of the parties involved.

4. Purpose:

• Hedging: Companies or investors use FX forwards to lock in exchange rates and mitigate the risk of currency fluctuations. For instance, a company expecting to receive or make a payment in a foreign currency in the future can use an FX forward to secure the rate today, avoiding potential adverse movements in the exchange rate.

• Speculation: Traders may use FX forwards to speculate on future movements in exchange rates, hoping to profit from favorable changes in the rate.

• Settlement: On the maturity date, the contract is settled by exchanging the agreed-upon amounts of currency at the forward rate. This can be done through physical delivery of the currencies or by cash settlement, depending on the terms of the contract.
  

Example:

Suppose a U.S. company expects to receive €1 million in three months and is concerned about a potential decline in the euro’s value. They can enter into an FX forward contract to sell €1 million and buy U.S. dollars at a rate agreed upon today. If the forward rate is 1.2000, they will receive $1.2 million (1 million euros × 1.2000) on the contract’s maturity date, regardless of the spot rate at that time.

In summary, an FX forward is a contract that locks in an exchange rate for a currency exchange to be completed at a future date, allowing businesses and traders to manage currency risk or speculate on future exchange rate movements.