What a forward does
A forward contract fixes today the exchange rate for an agreed amount, to be exchanged on a future date or within a future window. It is binding on both sides. On the settlement date the business delivers the currency it sold and receives the currency it bought at the contract rate, whatever the market rate is on that day.
The purpose is to take the exchange rate out of a future cash flow, so that a price, a margin or a budget can be planned in the home currency. A forward is not meant to beat the market. Some forwards will turn out better than the rate on the settlement date and some worse; that is the price of certainty.
How the forward rate is set
The forward rate is the spot rate adjusted for the difference between the interest rates of the two currencies over the term. The adjustment is quoted in forward points. It is arithmetic, not a forecast of where the rate is going.
Spot USD/CAD is 1.3700. US dollar interest rates are 3.25% and Canadian dollar rates are 2.50%.
- Three month forward rate1.3675 (25 points below spot)
- Six month forward rate1.3650 (50 points below spot)
Because the US dollar earns the higher interest rate in this example, it trades at a forward discount. An exporter selling US dollars forward receives fewer Canadian dollars than at spot, and an importer buying them pays fewer. When the interest rate difference runs the other way, so do the points. Quoted forward rates also include the provider's spread.
Fixed date, window and open forwards
| Type | How it settles | Suits | Bear in mind |
|---|---|---|---|
| Fixed date forward | The full amount on one agreed date | Receipts and payments with a known amount and date | Changing the date means settling early or extending, at a cost or benefit set by the market at the time |
| Window forward | In parts, at any time within an agreed window ending on the maturity date | Payments expected within a period but not on a known day | The rate reflects the flexibility; any balance not drawn by maturity must be settled then |
| Open forward | In parts, at any time from the trade date to maturity | Flows that are known in total but not in timing | As for a window forward, with the widest timing flexibility priced into the rate |
All forwards require a credit facility. Window and open forwards are subject to credit approval.
What forwards support
- Budget certainty. Rates booked at or better than the budget rate secure the plan for the amount hedged.
- Margin protection. A fixed price quoted in a foreign currency keeps its home currency margin when the rate is fixed at the time the price is agreed.
- Forecast cash flow management. Known rates on future receipts and payments make the home currency cash forecast reliable for the amount hedged.
- Layered hedging. Hedging a growing share of each period as it approaches, for example a quarter of the forecast at nine months, half at six months and three quarters at three months, spreads the rates achieved over time and adds cover as forecasts firm up.
- Exposure matching. A forward sized and dated to an invoice offsets that invoice exactly, which keeps reporting simple.
A forward protecting a receivable
The manufacturer agrees to sell equipment for $400,000 USD, payable in 90 days. Its costs are $500,000 CAD. Spot is 1.3700, so the sale was priced for $548,000 CAD and a margin of $48,000 CAD. To protect that margin it sells $400,000 USD forward for 90 days at 1.3675, securing $547,000 CAD.
| USD/CAD in 90 days | Margin without the forward (CAD) | Margin with the forward (CAD) | Forward on its own (CAD) |
|---|---|---|---|
| 1.3300 | $32,000 | $47,000 | +$15,000 |
| 1.3700 | $48,000 | $47,000 | −$1,000 |
| 1.4000 | $60,000 | $47,000 | −$13,000 |
With the forward, the margin is $47,000 CAD whatever the rate. The last column shows the forward valued on its own. At 1.4000 it shows a loss of $13,000 CAD, but the receivable is worth $13,000 CAD more than planned, and together they deliver exactly the rate that was fixed. Judging a hedge by its own value, without the exposure it protects, gives the wrong answer.
When the underlying exposure changes
A forward stays in place when the business behind it changes. A customer pays early or late, an order is reduced or cancelled, a forecast is revised. The contract still has to be dealt with, and each of the usual adjustments is priced at the market rates of the day it is made.
- Early settlement. If the cash arrives before the settlement date, the forward can be settled early. The rate is adjusted for the forward points between the new date and the original one, which can be a small cost or a small benefit depending on the interest rates of the two currencies.
- Extension. If the cash arrives late, the forward can be extended to a later date at a rate based on current market rates. Where the contract shows a loss against the market, the provider may require that loss to be settled, or may agree to carry it into the new rate, subject to credit approval. An extension does not remove a loss.
- Partial drawdowns. A window or open forward can be used in parts as invoices are paid, each at the contract rate. Whatever has not been drawn by maturity must still be settled.
- Restructuring. When a forecast is revised, several contracts may need new amounts or dates. That usually means closing some contracts and booking others, each at current rates.
- Cancellation or close out. A forward that is no longer needed is closed by booking an offsetting contract for the same date. In the example above, if the order were cancelled when the forward rate for the original date was 1.4000, the business would buy $400,000 USD forward at 1.4000 against its contract to sell at 1.3675. The two contracts settle against each other at a cost of about $13,000 CAD, before the provider's spread.
None of these adjustments is automatic. Each needs the provider's agreement and available credit, is priced at the market rates of the day, and can produce a cost. A hedging policy should say who may approve them.
What forwards do not do
- They do not cover volume risk. If the exposure turns out smaller than the forward, the excess is an open position in its own right.
- They use credit. A forward is a commitment, so it requires a credit facility. Under the terms of some facilities, a provider may ask for margin or collateral if the forward's value moves against the business.
- They need funds on the settlement date. The currency being sold must be available when the contract settles, whether or not the customer has paid.
- They give up favourable moves. That is the purpose, but it should be a decision the business has made, not a surprise.
In Vantry ATI, clients of Vantry Capital Inc. book fixed date, window and open forwards within their credit terms, and draw them down against payments as invoices fall due.
This article is general information about managing currency risk. It is not investment advice or a recommendation to use any instrument, and examples use illustrative rates and amounts, not quotations. Products are offered in Canada by Vantry Capital Inc., subject to eligibility and credit approval.