Saturday 3 September 2011

FX Forward Contract to Protect your Hard Earned Cash

FX forward contract is in introduced in forex market with the primary purpose of hedging foreign currency investment of the global clients. FX forward contract is an agreement between two parties where in the rate for future delivery of transaction is decided based on the current market situation. This locked exchange rate is known as “forward exchange rate”. There are mainly two types of forward exchange rates: one is premium and another is discount forward exchange rates.

Before understanding forward exchange rate, it is important to know one more terminology-spot rate. Spot rate is the current market rate for particular currency. When FX forward contract is offering forward rate which is higher than spot rate of that currency, it is known as premium and in exactly reverse condition when forward rate is lower than the spot rate, it is known as discount. To understand this premium and discount FX forward contract, let's consider the following example:

The quotes for currency pair GBP/USD are as below :
GBP/USD spot :: 1.95/97
GBP/USD 3 months :: 1.96/99

In above example, you can see that the spot rate of GBP/USD is 1.95 and after 3 months banks can offer the forward rate of 1.96 means GBP would be more expensive at that time. Thus, GBP is premium against USD.

There is one more terminology which is related to FX forward contract rate and spot rate. It is “swap points”. Swap point is the difference between the spot rate and forward rate. Let's calculate the swap points for above example:

1.96-1.95/1.99-1.97=1/2(swap points low/high)

If we know the spot rate and premium or discount then we can calculate FX forward rate:

Like in example discussed above spot rate was 1.95 and if forward premium is 2 for 3 months then the forward exchange rate offered by bank or forex firm will be 1.97.

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