What Is Forward Foreign Exchange ?

If a person signs a contract which requires the purchase or sale of foreign exchange at some future date, then he faces risks of fluctuating exchanges between the time the contrast is signed and the buying and selling of foreign money. The risk of fluctuation can be avoided by entering into a contract for the future purchase or sale of foreign exchange. The buying and selling of foreign exchange at a stipulated period and payable at some future date is known as forward exchanges in economics.

The importer and exporter of commodities shift the risk of fluctuating exchange in terms on to the bankers. The bankers quote the rate of forward exchange in terms of sport rate. If the bank pays less of foreign money for a unit of domestic currency as compared to the shop rate, the forward exchange is said to be at a premium and if it gives more of foreign money for a given unit of domestic currency than the sport rate, the forward exchange is said to be a discount.

The forward exchange will be coated at a premium or at a discount depends upon the currency conditions in the country and the rates of interest at home and abroad. If the banks anticipate the depreciation in the value of the foreign currency of a particular country, forward rates will be quoted at a premium. If the rates of interest in the foreign country are higher than at home, and the bank can make profit by transferring the funds, the forward rate will be quoted at a discount.

Forward exchange rate or forward contract as it is called is basically a commitment legally binding two parties in a forward contract where the two parties the buyer and the seller agree to exchange currencies at a fixed rate.

Normally this rate is higher that the rate in the market which is present rate also called as spot rate. The rate for the day.

Normally business men or companies which deals in exports and imports deal a lot in forward contract because in forward contract they can avert the risk of currency rates fluctuations.

Suppose I am importing some machine whose price is fixed and is in dollars and I am supposed to pay the seller company in dollars after three months.

I would see if the prevailing market rate is reasonable then I would simply buy the required amount of dollars and keep them for three months but normally forward rates are less so I would get into a forward contract with a dealer and set date and rate after three months today.

This contract where only agreement takes place the actual transaction takes place after a period of time normally in weeks and months is called forward rate or forward exchange.

The the case which I illustrated also explains the concept of hedging where the company or any buyer is risk averse.