What is a Forward Deal and How Does It Work?

What is a Forward Deal and How Does It Work?

Foreign exchange (forex) forward deals are contracts that are used as a hedge when an investor has a commitment to either take or make a forex payment at a specified date in the future. It is essentially a contract between a buyer and seller to either buy or sell a specific currency at a specific spot rate on the specified date. It helps the investor cover or hedge future exchange rate movements, and when the data of the payment and the last date of the forward deal is agreed upon, the investor is said to have “locked in” the forex payment amount.

What this essentially means is that with a forward contract, the seller has set a future forex exchange rate without having to incur any upfront costs. However, one should check with their broker regarding which currencies can be used for forward deals because not all currencies might be offered under such contracts.

How Does It Work?

On entering into a forward contract, the buyer and seller agree to the quantity, price per unit and date on which the currency will be exchanged. On the agreed upon date, the buyer needs to pay the seller the price that they have agreed upon in return for the predetermined quantity of assets. This means that if the spot price is lower than the forward price that had been decided upon in the contract, the seller makes a profit, while the buyer makes a loss. Therefore, when it comes to currency forward deals, the two parties could merely agree to the loss or profit amount rather than physically exchanging currencies.

Why Trade Forwards

easyMarkets is one of the few brokers that actually offers forwards to its retail clients; generally it is a product reserved for institutional clients, banks, brokers and corporations.

Forward options are used when one party wants to perform a transaction at a future date in a foreign currency: for example, if you want to buy something from Japan, but you won’t be charged until a few weeks later. You agreed to pay the person selling you the item 100 USD but their local currency is Yen.

You cannot guarantee that your 100 USD will be worth the same amount of Yen in a few weeks, as it is today. To avoid you paying more or the seller receiving less – a forward contract is created, which in very simple terms locks in the current rate of a currency pair at a future date.

In trading terms, forward contracts are used for hedging reasons – or to help mitigate and manage your risk. Essentially if the price of currency pair drops the trader is fully protected, but does not benefit if the price of the currency pair increases.