Agree today, exchange in time:a forward fixes the future's line.
An agreement to buy or sell a currency at a predetermined price on a specific future date.
Forward contracts are used by businesses and traders to hedge against exchange rate fluctuations.
In plain words
A forward contract is an agreement made today to exchange one currency for another on a set future date, at a rate fixed now. Nothing is exchanged until that date. It is a private agreement between two parties, not a standard contract traded on an exchange.
See it move
Stage 2 of 3: Waiting period
Why it matters
Businesses use forwards to know in advance what a future foreign payment will cost. The forward rate usually differs from today’s rate, because it reflects the difference in interest rates between the two currencies over the period.
Worked example
An example only. The figures are round and invented for the arithmetic: they are not market prices.
A firm holding euros must pay 1,000,000 US dollars in three months and agrees a forward rate of EUR/USD 1.2500 (invented figures).
- 1Cost fixed today = 1,000,000 ÷ 1.2500 = 800,000 euros
- 2Without the forward, at 1.20001,000,000 ÷ 1.2000 = about 833,333 euros
- 3Without the forward, at 1.30001,000,000 ÷ 1.3000 = about 769,231 euros
The firm pays 800,000 euros whichever happens: it is protected from the first outcome and gives up the benefit of the second.
A common mistake
A forward rate is sometimes read as a forecast of where the exchange rate is heading. It is calculated from today’s rate and the two interest rates, and fixing it removes favourable moves as well as unfavourable ones.
Check yourself
Educational information, not investment advice or a recommendation to trade.