Outright Forward: What it is, How it Works

What Is an Outright Forward?

An outright forward, or currency forward, is a currency contract that locks in the exchange rate and a delivery date beyond the spot value date. It is the simplest type of foreign exchange forward contract and protects an investor, importer or exporter from exchange rate fluctuations.

Understanding Outright Forwards

An outright forward contract defines the terms, rate and delivery date, of the exchange of one currency for another. Companies that buy, sell or borrow from foreign businesses can use outright forward contracts to mitigate their exchange rate risk by locking in a rate that they deem to be favorable.

For example, an American company that buys materials from a French supplier may be required to provide payment for half of the total value of the euro payment now and the other half in six months. The first payment can be paid for with a spot trade, but in order to reduce currency risk from the possible appreciation of the Euro vs. the U.S. dollar, the American company can lock in the exchange rate with an outright forward purchase of Euros.

The price of an outright forward is derived from the spot rate plus or minus the forward points calculated from the interest rate differential. A point to note is that the forward rate is not a forecast of where the spot rate will be on the forward date. A currency that is more expensive to purchase for a forward date than for spot date is considered to be trading at a forward premium while one that is cheaper is said to be trading at a forward discount.

The spot foreign exchange market generally settles in two business days with the exception of the USD/CAD, which settles on the next business day. Any contract that has a delivery date that is longer than the spot date is termed a forward contract. Most currency forward contracts are for less than 12 months, but longer contracts are possible in the most liquid currency pairs. Foreign exchange forward contracts can also be used to speculate in the currency market.

Settlement

An outright forward is a firm commitment to take delivery of the currency that was purchased and make delivery of the currency that was sold. The counterparties must provide each other with instructions as to the specific accounts where they take delivery of currencies.

An outright forward can be closed out by entering into a new contract to do the opposite which can result in either a gain or loss versus the original deal, depending on market movements. If the close out is done with the same counterparty as the original contract, the currency amounts are usually netted under an International Swap Dealers Association agreement. This reduces the settlement risk and the amount of money that needs to change hands.