Understanding corporate finance: foreign exchange: forward exchange rates
Forward exchange rates
Currency may be traded for immediate delivery, or for future delivery. Companies are likely to enter into currency forward contracts or currency futures in order to hedge exchange risks (CFM12120).
You will see quoted in the financial press forward exchange rates for different currencies. This is the price at which the currency can be bought, or sold, today for delivery at a future date - typically you will see exchange rates quoted for delivery in one month’s, three months’ or a year’s time.
For example, a company that knows it is going to have to repay a loan denominated in euros in 12 months’ time may enter into a forward contract to buy the necessary euros.
Suppose that the company borrows €500,000 on 1 July 2002 and must repay it on 30 June 2003. On 1 July 2002 it enters into a forward contract to buy €500,000 in a year’s time at a rate of €1.6130/£. The company now knows that it will cost £309,981, in sterling terms, to repay the loan. If the euro spot rate on 1 July 2002 is €1.6121/£, so that the amount which the company borrows is worth £310,154, the company has ‘locked in’ a profit of £173 on the loan.
If the company waited until 30 June 2003 and then bought €500,000 on the spot market, it might make a greater exchange gain, but it could also make a loss. By entering into a forward contract to buy the currency, the company foregoes the chance of additional profit, but protects itself from the risk of loss.