The Forward Market

Forward exchange operations carry the same credit risk as spot transactions but for longer periods of time; however, there are significant exchange risks involved.

A forward contract between a bank and a customer (which could be another bank) calls for delivery, at a fixed future date, of a specified amount of one currency against dollar payment; the exchange rate is fixed at the time the contract is entered into. Although the euro is the most widely traded currency at present, active forward markets exist for the pound sterling, the Canadian dollar, the Japanese yen, and the Swiss franc. In general, forward markets for the currencies of less-developed countries are either limited or nonexistent.

In a typical forward transaction, for example, a U.S. company buys textiles from England with payment of £1 million due in 90 days. Thus, the importer is short pounds—that is, it owes pounds for future delivery. Suppose the spot price of the pound is $1.97. During the next 90 days, however, the pound might rise against the dollar, raising the dollar cost of the textiles. The importer can guard against this exchange risk by immediately negotiating a 90-day forward contract with a bank at a price of, say, £1 = $1.98. According to the forward contract, in 90 days the bank will give the importer £1 million (which it will use to pay for its textile order), and the importer will give the bank $1.98 million, which is the dollar equivalent of £1 million at the forward rate of $1.98.

In technical terms, the importer is offsetting a short position in pounds by going long in the forward market—that is, by buying pounds for future delivery. In effect, use of the forward contract enables the importer to convert a short underlying position in pounds to a zero net exposed position, with the forward contract receipt of £1 million canceling out the account payable of £1 million and leaving the importer with a net liability of $1,980,000:

According to this T-account, the forward contract allows the importer to convert an unknown dollar cost (1,000,000 X e1, where e1 is the unknown spot exchange rate—$/£—in 90 days) into a known dollar cost ($1,980,000), thereby eliminating all exchange risk on this transaction.

Exhibit 7.8 plots the importers dollar cost of the textile shipment with and without the use of a forward contract. It also shows the gain or loss on the forward contract as a function of the contracted forward price and the spot price of the pound when the contract matures.

The gains and losses from long and short forward positions are related to the difference between the contracted forward price and the spot price of the underlying currency at the time the contract matures. In the case of the textile order, the importer is committed to buy pounds at $1.98 apiece. If the spot rate in 90 days is less than $1.98, the importer will suffer an implicit loss on the forward contract because it is buying pounds for more than the prevailing value. However, if the spot rate in 90 days exceeds $1.98, the importer will enjoy an implicit profit because the contract obliges the bank to sell the pounds at a price less than current value.

Three points are worth noting. First, the gain or loss on the forward contract is unrelated to the current spot rate of $1.98. Second, the forward contract gain or loss exactly offsets the change in the dollar cost of the textile order that is associated with movements in the pound’s value. For example, if the spot price of the pound in 90 days is $2.01, the importer’s cost of delivery is $2.01 million. However, the forward contract has a gain of $30,000, or 1,000,000 X (2.01 − 1.98). The net cost of the textile order when covered with a forward contract is $1.98 million, no matter what happens to the spot exchange rate in 90 days. (Chapter 10 elaborates on the use of forward contracts to manage exchange risk.) Third, the forward contract is not an option contract. Both parties must perform the agreed-on behavior, unlike the situation with an option in which the buyer can choose whether to exercise the contract or allow it to expire. The bank must deliver the pounds, and the importer must buy them at the pre-arranged price. Options are discussed in Chapter 8.