Forward Contracts

Forward Contracts are a form of exchange contract which can be organized to lock in a given price to exchange currencies at a pre-determined future date.

They are usually quoted in terms of the difference between the spot rate and the forward rate.  This difference is known as forward margin.  It is either forward premium (+) or forward discount (-). The spot rate refers to the current exchange rate, where the delivery of the exchange takes place immediately.

The forward rate spread will always be greater than the spot rate. This means that the gap between the 2 quoted prices is larger. This is due to the fact that delivery happens in the future and therefore uncertainness and risk are present. The larger this spread is the more volatile or risky the market is, and as such the exchange rate dealer will pocket a greater profit. The higher the forward rate premium or discount the more uncertain or risky the relative exchange rate is in terms of the local or domestic currency.

Example

Say the current or spot exchange rate is the following:

USD 0.7455 / 0.7500 AUD

And the 6 month forward rate given is 10/15. Now to work out the forward rate in terms of the bid and ask exchange, we would need to incorporate the forward rate into the current spot rate (remembering that the spread in the forward rate must be greater than that in the spot rate). The current spread in the spot rate is 45 points. Therefore if we use the forward rate as a premium (i.e. adding the forward rate) then it would appear as the following:

Therefore the forward rate is:

USD 0.7465 / 0.7515 AUD

And the spread for the forward rate is: 50 points

(0.7515 – 0.7565)

Which would be correct as the forward rate spread is greater than the spot rate spread Or in other words 50 is greater than 45. And because we have added the forward margin onto the spot rates, this means that the forward rate which we have been given is quoted at a forward premium. The following is INCORRECT and is an example of what NOT TO DO!!!

A WRONG Example

Using the same information as the correct example above, the current or spot exchange rate is the following:

USD 0.7455 / 0.7500 AUD

And the 6 month forward rate given is 10/15. Therefore the spot spread = 45 points

By expressing the forward margin as a forward discount (subtracting the forward margin from the spot rate) we can see that the forward rate spread is not less than the spot.

0.7485 – 0.7445 = 40 points

Therefore this would be incorrect!!! The most important thing to realize when calculating forward rates is that the forward rate spread must be bigger than the current spot rate spread.