Outright Forward
Outright Forward, also referred to as a forward, is a type of foreign currency exchange forward contract functioning in the outright forward market. Such a contract is a firm and binding obligation agreed upon by both parties. It concerns the exchange of one currency for a counter currency at a forward rate at a specified date in the future. Neither the rate nor the date is subject to changes. Therefore, the currencies are not to be exchanged till the given value date arrives[1][2].
There is a wide range of maturities available in this market, whereas the completion of all transactions in the spot exchange market is always due within two days (T + 2)[3]. Banks at large quote the forward exchange rates for some fixed periods, for instance one week, one month, three months, six months or a year. Calculation of rates for broken dates is also possible[4]. To establish a forward rate which is to be used for delivery on a given value date, a notion of forward points (known as pips) must be applied. The forward points are the number of basis points deducted from or added to the spot rate of a currency pair [5][6].
Forward Premium vs. Forward Discount since a forward rate on a currency A is lower than a spot rate, then the currency A is trading at a forward discount. Accordingly, the currency B is trading at a forward premium [7].
Strengths and Weaknesses
Main advantages and disadvantages of outright forward contracts include [8]:
- Such a contract helps to protect oneself against unpredictability, instability and volatility of markets
- It can be used for speculation and risk management
- Investors, importers, exporters etc. have a means to pre-empt the adverse effects of fluctuation in exchange values
- The forwards do not entail any up-front payments
- However, the parties agreeing beforehand on a fixed rate forego potential profits, as a set forward rate may differ significantly from a future spot rate. Thus, profits may be lower.
Examples of Outright Forward
- An exporter who expects to receive payment in a foreign currency may enter into an Outright Forward to lock in the exchange rate and the expected delivery date of the payment. This will ensure that the exporter will receive the same amount of their domestic currency regardless of fluctuations in the foreign currency exchange rate.
- A company may enter into an Outright Forward contract to hedge their foreign currency exposure. By locking in the rate and delivery date of the payment, the company can be sure that the amount of their domestic currency received will be the same, regardless of fluctuations in the exchange rate.
- A business may enter into an Outright Forward contract to purchase a foreign currency in advance of a payment due date. This allows the business to take advantage of favorable exchange rates and lock in the amount of their domestic currency that they will receive.
Advantages of Outright Forward
An Outright Forward contract offers several advantages to both parties involved in the agreement:
- Risk Management: The contract provides a method for managing currency risk as the rate and date of the transaction are fixed and both parties are obligated to complete the transaction.
- Cost Savings: The contract also helps to save cost as the rate is fixed and the cost of the transaction can be calculated in advance.
- Flexibility: Outright Forward contracts offer flexibility as the amount to be exchanged can be customized as per the needs of the parties.
- Time Savings: The contract helps to save time as both parties need not worry about market fluctuations as the rate and date are fixed.
Limitations of Outright Forward
An Outright Forward is subject to several limitations, including:
- Counterparty Risk: There is a risk that the other party to the forward transaction may default on the agreement, leaving the investor unable to receive the currency they were expecting.
- Currency Risk: If the exchange rate moves in a direction unfavorable to the investor, they may incur a loss on the transaction.
- Settlement Risk: If the other party to the agreement fails to deliver the currency on the agreed-upon date, the investor may not receive the currency they are expecting.
- Interest Rate Risk: If the interest rate on the currency they are expecting to receive is lower than the interest rate on the currency they are paying, the investor may incur a loss.
An introduction to the other approaches related to Outright Forward is that they are contracts that involve the exchange of one currency to another currency at a specified rate and date in the future. The following are some of the other approaches related to Outright Forward:
- Currency Swap - A currency swap is a foreign exchange transaction that involves the exchange of one currency for another between two parties at a predetermined exchange rate for a specified period of time.
- Forward Exchange Contract - A forward exchange contract is a type of foreign exchange derivative contract that allows two parties to agree to exchange two different currencies at a pre-determined exchange rate at a specified date in the future.
- Currency Option - A currency option is a type of foreign exchange derivative contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a predetermined exchange rate at a specified date in the future.
In summary, there are several types of contracts related to Outright Forward, including currency swaps, forward exchange contracts, and currency options. All of these contracts involve the exchange of one currency for another at a predetermined rate and date in the future.
Footnotes
| Outright Forward — recommended articles |
| Interest Rate Collar — Currency certificate — Forward Swap — Forward points — Basis swap — Forward Exchange Contract — Alternative futures — Commodity swap — Swap Ratio |
References
- Brown B., (2017)., The Forward market in Foreign Exchange: A Study in Market-making, Arbitrage and Speculation Routledge
- CFA Institute,(2017)., CFA Program Curriculum 2018 Level I John Wiley & Sons
- Chisholm A., (2009)., An Introduction to International Capital Markets: Products, Strategies, Participants John Wiley & Sons
- Neftci S.,(2008)., Principles of Financial Engineering Academic Press
Author: Piotr Łabuz
