Table of Contents:

Forward Exchange rate

The forward exchange rate refers to an exchange rate that is quoted and traded today, but for delivery and payment on a specific future date. They specify a value and date further into the future. Typically 30 days, 60 days, 90 days...etc.

• Example: you might want to trade 1,000 Euros for $1,400 USD one month in the future. So the 30 day forward exchange rate is $1.4 / EU. To "sell Euros forward" means that you are going to give the 1000 Euros, and if you are going to "buy Dollars forward" that means you are going to get the $1,400 (in the future, in this example).

• Example: if a company is importing and knows that they must pay the foreign supplier in foreign currency at a time of 30 days in the future, that company might be afraid of a currency change , which would result in them owing much more money (in their local currency). To mitigate this risk, the company might want to "lock-in" an exchange rate in the future...by using a "forward" exchange. To do this, the importing company would make a deal with their local bank to buy the foreign currency at a specific rate (in 30 days in the future). By agreeing to "sell dollars forward", and to "buy foreign currency forward", the importer has guaranteed that they will have the right amount of foreign currency on hand in the future (to pay the supplier), and they have eliminated the risk. This is like buying insurance against the risk of FX fluctuations.

Forward exchange rates are different that than the spot rate based on the difference in interest rates in the two countries. For more about how the forward FX rate is set, please see "interest rate parity" section below.

How Forward rates are set

If you compare two interest rates of two countries, then the one with the HIGHER interest rate will have the (LOWER) currency depreciate in the futures (and forward) markets.   Imagine if the Japanese Yen had a lower rate of return (than the US dollar) for an investment, then you would expect that investors should be compensated for that lower return by appreciation of their currency...or else...no one would keep their money in Japanese Yen...everyone would convert it to USD.  So, the currency with the lower interest rate must have appreciation, and the currency with the higher interest rate must see depreciation. (for more discussion, see interest rate parity).

How to buy a forward contract

• you need a relationship with a bank
• and they have to trust you (there is no collateral in a forward contract)
• unlike a Futures market contract which you purchase with a stock broker using stock as collateral (margin account)

Where to Find Forward exchange rates:

1. Financial times online
2. http://www.ozforex.com.au/cgi-bin/forwardRates.asp

Risk Management

 When dealing with foreign exchange risk, you have a few choices as a business manager

1. Operationally hedge - balance your assets and liabilities so that currency is generated in revenues in the same country where liabilities are owed.   Another way to operationally hedge is to have operations in multiple countries, so that if one currency goes down, another will go up, etc.
2. Avoid - you can try to avoid currency risk by passing along the risk premium to your customers.  You can charge a risk premium, say for example 7% extra to all clients, and keep a fund ready for incase the currencies change, and then, that way...you will have money ready.  Its not a very good method, but some companies do it.
3. Protect yourself - hedge - transfer the risk to someone else that is more willing / able to take on that risk... if there is someone that is willing to take on risk for a fee, then sell them that risk, and take the money now.  This is the essence of currency hedging . 

• The four main choices for currency hedging are
  • (a) forward contracts  (see forward exchange rate)
  • (b) futures contracts  (see Futures market)
  • (c) options (see Options)
  • (d) use the money market to hedge
  • (d) sell your A/R to someone else  ....companies that buy your receivables at a discount.
    1. Bankers Acceptance -
       • is an agreement between an importer and exporter,
       • with payment in 30 days
       • cover goods in transit
       • irrevocable letter of credit (L/C) = confirmation + insurance + Bill of Lading (BL)
       • Then, if you have the irrevocable L/C...then you can get the "Bankers Acceptance
       • you sell the package of contracts
       • go to bank
       • sell those receivables at a discount...to get money today.
    2. factoring
       • might buy next 15 shipments
       • multiple shipments
       • but, because there is no guarantee, then the banks charge a higher commission
       • get money today
    3. forefeiting
       • committment by a country (government)
       • host country guarantee
       • popular in older times, and in Middle east.

More links

foreign currency trading

spot exchange rate

Currency

appreciation

depreciation