Intro to Forward Exchange Market

Intro to Forward Exchange Market

The forward transaction is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market.

The foreign exchange regulations of various countries, generally, regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions.

     Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract.

Forward Exchange Rate

        With reference to its relationship with the spot rate, the forward rate may be at par, discount or premium.

           

At Par: If the forward exchange rate quoted is exactly equivalent to the spot rate at the time of making the contract, the forward exchange rate is said to be at par.

           

At Premium: The forward rate for a currency, say the dollar, is said to be at a premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot market. The premium is usually expressed as a percentage deviation from the spot rate on a per annum basis.

           

At Discount: The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis.

The forward exchange rate is determined mostly by the demand for and supply of forward exchange. Naturally, when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par. The Forward market primarily deals in currencies that are frequently used and are in demand in the international trade, such as US dollar, Pound Sterling, Deutschmark, French franc, Swiss franc, Belgian franc, Dutch Guilder, Italian lira, Cana­dian dollar and Japanese yen. There is little or almost no For­ward market for the currencies of developing countries. For­ward rates are quoted with reference to Spot rates as they are always traded at a premium or discount vis-à-vis Spot rate in the inter-bank market. The bid-ask spread increases with the forward time horizon.