Equity Derivatives and Structured Products Glossary: Currency forward


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Currency forward

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Currency forward

Currency forward

An agreement to Exchange a specified amount of one Currency for another at a Future date at a certain rate. The Exchange of currencies is priced so as to allow no Risk-free Arbitrage. In other words, pricing is not a market estimate of the Spot rate at that date, but is made according to the two currencies’ respective Interest rates. For example, assuming that Eurosterling Interest rates are 10% and Eurodollar 5%, and the US dollar/sterling Spot rate is 1.75, the Forward rate should reflect the 5% Interest rate advantage of depositing money in sterling. Thus the 12-month Forward rate should be 1.6695. Forwards are more appropriate than options if a company has a strong directional view of expected movements in Exchange rates. But certainty is rare and Hedging entirely with forwards may leave a company locked into unfavourable Exchange rates. Unlike options, forwards do not enable companies to take advantage of favourable Currency movements. The purchaser of a Forward, unlike the purchaser of a Future, carries the Credit risk of the firm from which it makes the purchase. Since the contracts are not easily reassignable, it is difficult to reduce this Risk.

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