What Is a Forward Exchange Contract (FEC)?
A forward exchange contract (FEC) is a special over-the-counter (OTC) foreign currency (forex) transaction that allows traders to exchange currencies that are infrequently traded. These may include minor currencies as well as blocked or otherwise inconvertible currencies. Forward contracts are agreements between two parties to exchange a pair of currencies at a specific time in the future. These transactions typically take place on a date after the spot contract settles and are used to protect the buyer from currency price fluctuations.
Key Takeaways
- A forward exchange contract is an agreement between two parties to effect a currency transaction, and may involve a currency pair not readily accessible on forex markets.
- FECs are traded OTC with customizable terms and conditions.
- FECs are used as a hedge against risk since they protect both parties from unexpected or adverse movements in the currencies' future spot rates.
Formula and Calculation of Forward Exchange Contract (FEC)
The forward exchange rate for a contract can be calculated as:
Forward rate = S x (1 + r(d) x (t ÷ 360)) ÷ (1 + r(f) x (t ÷ 360))
Where:
- S = the current spot rate of the currency pair
- r(d) = the domestic currency interest rate
- r(f) = the foreign currency interest rate
- t = time of contract in days
Understanding Forward Exchange Contracts (FECs)
As noted above, FECs are OTC transactions that may be used to trade currencies that aren't commonly traded in the forex market, including minor currencies and blocked or inconvertible currencies. An FEC involving such a blocked currency is known as a non-deliverable forward (NDF).
FECs are not traded on exchanges and they don't trade standard currency amounts. These contracts cannot be canceled except by the mutual agreement of both parties involved. The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position.
All FECs feature:
- Currency pair
- Notional amount
- Settlement date
- Delivery rate
They also stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction. The contract's rate of exchange is fixed and specified for a future date, allowing the parties involved to better budget for future financial projects and be aware of their income or costs from the transaction ahead of time. The nature of FECs protects both parties from unexpected or adverse movements in the currencies' future spot rates.
Forward exchange rates for most currency pairs can usually be obtained for up to 12 months in the future or up to five years for the four major pairs.
Special Considerations
The largest forward exchange markets include the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), and Brazilian real (BRL). The largest OTC markets are in London, with other active markets in New York, Singapore, and Hong Kong. Some countries, including South Korea, have limited but restricted onshore forward markets in addition to an active NDF market.
The largest segment of FEC trading is done against the U.S. dollar (USD). There are also active markets using the euro (EUR), the Japanese yen (JPY), and, to a lesser extent, the British pound (GBP) and the Swiss franc (CHF).
Forward Exchange Rates
Forward exchange rates for most currency pairs are available for up to 12 months in advance.
There are four pairs of currencies known as the major pairs:
- U.S. dollar and euro (USD/EUR)
- U.S. dollar and Japanese yen (USD/JPY)
- U.S. dollar and the British pound sterling (USD/GBP)
- U.S. dollar and the Swiss franc (USD/CHF)
Exchange rates can be obtained for a period of up to 10 years for these pairs. Contract times as short as a few days are also available from many providers. Although a contract can be customized, most entities won't see the full benefit of an FEC unless setting a minimum contract amount at $30,000.
Example of Forward Exchange Contract (FEC)
Here's a hypothetical example to show how FECs work. Let's assume that the U.S. dollar and Canadian dollar (CAD) spot rate is $1 (CAD) buys $0.80 (USD.) The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. In this case, the three-month USD/CAD FEC rate would be calculated as:
Three-month forward rate = 0.80 x (1 + 0.75% x (90 ÷ 360)) ÷ (1 + 0.25% x (90 ÷ 360)) = 0.80 x (1.0019 ÷ 1.0006) = 0.801
The difference due to the rates over 90 days is one one-hundredth of a cent.
What Is a Currency Forward?
A currency forward is a foreign exchange contract. It guarantees the exchange rate for a future currency sale or purchase by locking it in. Because it comes with a rate that's locked in, it is a binding agreement. As such, the buyer and seller cannot break the contract and must adhere to it. This type of contract doesn't trade on an exchange, rather, it is traded over the counter.
What Is the Most Actively Traded Currency Pair?
The currency pair that is most actively traded in the foreign exchange market is the euro/U.S. dollar (EUR/USD). Trading in this pair accounts for about 30% of the transactions in the foreign exchange market.
What are Blocked and Non-Convertible Currencies?
Non-convertible currencies are those that cannot be freely exchanged for other currencies on the forex market. This restriction is usually imposed by the issuing country's government.
Blocked currencies refer to funds that are restricted from being transferred out of the country. This term often applies to convertible currencies that cannot be moved outside of the issuing country due to specific government relations.
Even though both non-convertible and blocked currencies are legal tenders in their country of origin, it is virtually impossible to exchange them for another currency. The North Korean won (KPW) is an example of a non-convertible currency. Indian rupee is an example of a partially blocked currency.
The Bottom Line
Forward exchange contracts are special over-the-counter contracts that traders sometimes use to trade less common currency pairs. These contracts can be somewhat complex, and novice traders should do their homework before considering them. Doing your research can help you minimize losses and avoid investment shock.
