FX Forward Contract Fundamentals

Forward contracts are by far the most prevalent foreign exchange derivative instrument used in the marketplace. A forward secures the value of an underlying position by providing 100% protection against unfavorable market moves beyond the “all in” forward rate, while giving up 100% of the participation in favorable market moves. A forward contract will almost always finish in either an asset or liability position at maturity depending on the ending spot rate. Forwards are easy to understand, widely available, and require no upfront premium. Forwards are particularly attractive for firms that seek a symmetrical payoff profile, where the hedge achieves largely equal and offsetting gains and losses related to the underlying foreign exchange exposure.

Forward contracts involve the exchange of two currencies at an agreed upon rate on the date of the contract for settlement on a date more than two business days in the future. Forward contracts include both deliverable and non-deliverable forwards, which are also known as NDFs. A non-deliverable forward (NDF) is a cash-settled forward contract on a restricted or non-convertible foreign currency, as opposed to a deliverable forward which has the option of cash settlement or delivery of the currency. According to the Bank for International Settlements 2013 Triennial Central Bank Survey, daily trading volume in forward contracts reached $680 billion in April of 2013, accounting for 13% of total FX market volume, which is the highest percentage on record since the survey began.

To explain the fundamentals of FX forward contracts, the following 6 minute video clip from FX Initiative’s newly released course titled “FX Spot & Derivatives” discusses the basic concepts of forward contracts, including forward points, the forward point equation, and the “all in” forward rate.

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