FX forwards are contracts occurring within the foreign exchange market where market participants lock in exchange rates for the buying or selling of a currency on a predetermined date.
Sometimes known as currency forwards, FX forwards can be thought of as a customizable hedging approach.
In this sense, upfront margin payments are not required and all contracts are over-the-counter (OTC) due to the decentralized nature of the foreign exchange market.
Popularity of FX Forwards
FX forwards are popular given they are less restrictive than trade exchanges, such as exchange-traded currency futures, where the contracts can be structured to a specific sum and maturity date.
The date where participants enter the contact is known as the trade date while settlement convention is the term used to define the difference between trade and settlement date.
While FX forwards possesses a flexible contract composition, traders should know that once obligated and locked in there is no walking out until settlement date.
Additionally, the settlements of FX forward contracts can be handled via cash or a delivery basis.
It should be noted that FX forward rates are based upon interest rate differentials and do not take into due consideration an investors’ predictions.
All FX forwards, spot rates and interest rates are linked by interest rate parity (IRP), which is used to ensure no arbitrage opportunity occurs within the FX forward, FX spot market, and the two countries whose the contract is bond.
Given that interest rate differentials play a significant role in determining FX forward contracts, forex traders that possess strong fundamental trading analysis skills can take advantage of FX forwards by setting in a locked-in exchange rate for a future period.