Outright Forward

Outright Forward
See also

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.

Footnotes

  1. Brown B., (2017) Chapter 3
  2. CFA Institute, (2017) pp. 524
  3. Chisholm A., (2009) Chapter 3.1
  4. Brown B., (2017) Chapter 3
  5. Neftci S.,(2008) pp. 76
  6. CFA Institute, (2017) pp. 425
  7. CFA Institute, (2017), pp. 425
  8. Chisholm A., (2009) Chapter 3 & 3.1

References

Author: Piotr Łabuz