Forward Exchange Contract

Forward Exchange Contract (FEC): Definition and Overview

A forward exchange contract (FEC) is an over-the-counter (OTC) agreement between two parties to exchange a specified amount of one currency for another at a predetermined exchange rate on a future date. FECs are used to lock in exchange rates and protect participants from adverse currency movements. They can be customized to accommodate currencies that are rarely traded or subject to restrictions.

Key points:
* Traded OTC with customizable terms (amounts, dates, rates).
* Commonly used for hedging future currency exposures or for speculative positions.
* Can involve convertibles or restricted/blocked currencies; when a blocked or non-convertible currency is involved, the contract may be structured as a non-deliverable forward (NDF).

How FECs Work

Parties agree on:
* Currency pair
* Notional amount
* Delivery/settlement date
* Delivery (forward) rate

On the agreed settlement date the currencies are exchanged at the fixed forward rate, regardless of the prevailing spot rate. Contracts are generally binding and cannot be canceled without mutual consent.

Forward Rate Formula and Calculation

A commonly used approximation for the forward exchange rate is:

Forward rate = S × (1 + r(d) × (t ÷ 360)) ÷ (1 + r(f) × (t ÷ 360))

Where:
* S = current spot rate (domestic per foreign)
* r(d) = domestic interest rate (annual)
* r(f) = foreign interest rate (annual)
* t = time to settlement in days

Example (three-month USD/CAD):
* Spot S = 0.80 (USD per CAD)
* USD 3‑month rate = 0.75% → r(d)
* CAD 3‑month rate = 0.25% → r(f)
* t = 90 days

Three-month forward ≈ 0.80 × (1 + 0.0075 × 90/360) ÷ (1 + 0.0025 × 90/360)
≈ 0.80 × (1.0019 ÷ 1.0006) ≈ 0.801

The forward rate reflects interest-rate differentials between the two currencies.

Contract Features and Market Practice

Standard elements:
* Fixed exchange (delivery) rate for a future date
* Specified notional amount and settlement mechanics
* Use of prevailing spot rate on a fixing date when required by the contract

Market notes:
* Forward quotes are typically available up to 12 months ahead for most pairs; the four major pairs can often be quoted up to several years.
* Contract tenors can be as short as a few days.
* Many institutions set a practical minimum contract size (often around $30,000) to justify using an FEC.

Major currencies and markets:
* Frequently used currencies: USD, EUR, JPY, GBP, CHF, plus emerging-market and regional currencies.
* Active OTC centers: London, New York, Singapore, Hong Kong.
* Large forward activity exists for currencies such as CNY, INR, KRW, TWD, BRL, often subject to local restrictions.

Special Considerations

• Non‑deliverable forwards (NDFs): Used when one currency is non-convertible or blocked; settlement is typically in a convertible reference currency (e.g., USD) based on a reference spot fixing.
• Regulatory and capital-control constraints can limit deliverable forwards in some jurisdictions.
• Counterparty credit risk is present because FECs are OTC contracts—creditworthiness and collateral arrangements matter.
• Hedging benefit depends on correct assessment of currency exposures and contract sizing.

Short FAQs

What is a currency forward?
* A forward is an OTC contract that locks in an exchange rate for a future purchase or sale of currency. It is binding and used mainly for hedging.

Which currency pair is most actively traded?
* EUR/USD is the most actively traded pair, accounting for a large share of FX turnover.

What are blocked and non-convertible currencies?
* Non-convertible currencies cannot be freely exchanged on international markets, usually due to government restrictions. Blocked currencies are convertible domestically but cannot be transferred out of the country. Examples: North Korean won (non-convertible); some countries impose partial controls on currencies like the Indian rupee.

Summary

FECs provide a customizable, OTC mechanism to lock in future exchange rates, reducing exposure to currency volatility. They are widely used by companies and financial institutions for hedging cross-border cash flows and for managing currency risk, including in markets with restricted or illiquid currencies. When using FECs, consider tenor, interest-rate differentials, counterparty risk, and applicable regulatory constraints.