FX Forward


FinPricing offers:

Four user interfaces:

  • Data API.
  • Excel Add-ins.
  • Model Analytic API.
  • GUI APP.
View:

Currency Forward or FX Forward Introduction and Pricing Guide


FinPricing provides valuation tools for the following FX products:

  • FX Option
  • FX Basket Option
  • FX Compound Option
  • FX Barrier Option
  • FX Asian Option
  • FX TARN
  • FX Accumulators Fader
  • Check FinPricing valuation models

1. Currency Forward Introduction

A currency forward or FX forward is a contract agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date. Currency forwards are effective hedging vehicles that allow buyers to indicate the exact amount to be exchanged and the date on which to settle in the forward contract.

By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost. Currency forward settlement can either be on a cash or a delivery basis, provided that the option is mutually acceptable and has been specified beforehand in the contract. Forward contracts are one of the main methods used to hedge against exchange rate volatility, as they avoid the impact of currency fluctuation over the period covered by the contract.

Currency forwards are over-the-counter (OTC) instruments. Unlike standardized FX future, a FX forward can be tailored to a particular amount and delivery period. If an investor will receive a cashflow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency forward position that expires on the date of the cashflow.

The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations. By using FX forward contracts, investors can protect costs on products and services purchased abroad and protect profit margins on products and services sold abroad by locking-in exchange rates as much as years in advance.

Currency forwards can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. A currency forward contract has credit risk. In the case that one of the parties is unable to fulfill its obligation, the other party will have to sign another contract with a third party, thus being exposed to market risk at that time. By locking-in the exchange rates at which the currency will be bought, the party forfeits the opportunity of profiting from a favorable exchange rate movement.


2. Forex Market Convention

One of the biggest sources of confusion for those new to the FX market is the market convention. We need to make clear the meaning of the following terms in the forex market first.

  • FX quotation: The quotation EUR/USD 1.25 means that one Euro is exchanged for 1.25 USD. Here EUR (nominator) is the base or primary currency and USD (denominator) is the quote currency. One can convert any amount of base currency to quote currency byQuoteCurrencyAmount = FxRate * BaseCurrencyAmount
  • Spot Date: The spot date or value date is the day the two parties actually exchange the two currencies. In other words, a currency pair requires a specification of the number of days between the quotation date (trade date) and the Spot Date on which the exchange is to take place at that quote. Spot days can be different for each currency pair, although typically it is two business days.
  • Holidays: Each currency pair has a set of holidays associated with it. The holidays of a currency pair is the union of the holidays of the two currencies.
  • FX curves: The observed curves in the FX market are FX forward points/spreads that cannot be used to price a FX trade directly. One needs to bootstrap FX forward points into FX yield curves in order to conduct valuation. Note that FX yield curves are quite different from LIBOR yield curves or government yield curves. Find more details about FX curves.

3. FX Forward Rate

The FX forward rate can be represented as

FX forward rate in FinPricing

Here we want to emphasize that the discount factors of base currency and quote currency are derived from currency yield curves rather than LIBOR or treasury curves. This is another distinguished feature in the FX market.


4. Pricing FX Forward Contracts

The present value of a currency forward contract is given by

Pricing FX forward in FinPricing

The above description tells us that FX forward rates and FX forward contracts are different subjects/entities. Sometimes people are confused about them.