The forward exchange market is a market for contracts that ensure the future delivery of a foreign currency at a specified exchange rate. The price of a forward contract is known as the forward rate.
Forward rates are usually negotiated for delivery one month, three months, or one year after the date of the contract’s creation. They usually differ from the spot rate and from each other. If one currency is expected to depreciate against a second, it is said the first currency is selling at a discount on the forward market. The term selling at a premium on the forward market is used for cases in which appreciation is expected.
What determines the forward rate?
If there is no government intervention on the value of a currency, the forward market will be governed by supply and demand. In such a case it is possible that the forward rate provides information on the future spot rate, but ultimately uncertain. What is certain is that the forward rates reflect the expectations forward market participants have on the changes of the spot rate during the specified interval. If the forward rate and the spot rate are the same, forward market participants do not expect much change in the price of a currency over the given period of time.
Forward contracts can be used to hedge or cover exposure to foreign exchange risk.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder TBIL.co STATX Fund.