Foreign Exchange: A Practical Guide to the FX Markets

CHAPTER 6

Foreign Exchange Forwards

Money often costs too much.

—Ralph Waldo Emerson

INTRODUCTION TO FORWARDS AND FORWARD PRICING

In some ways, the financial markets involve transactions that are similar to more mundane experiences. While on a trip, I may need a place to sleep. I could simply attempt to locate lodgings as my bedtime approaches, but that could prove problematic. I may not be able to find a vacancy, but, even if I could, I would have no idea what I would have to pay (and would probably feel like I was being taken advantage of, upon hearing that there are vacancies, but that I would have to pay $400 for that evening’s stay). In short, many of us who travel tend to arrange for our hotel/motel accommodations in advance. That way, we are ensured that we can get what we would like—at a price that we feel is reasonable. A large number of foreign exchange trades are done in this fashion. If you arrange a currency trade, locking in a price (an exchange rate) and a quantity in advance, this is known as a “forward contract,” a “forward transaction,” a “forward trade,” or, simply, a “forward.”

There is no reason why you should expect the price in a forward trade to be the same as the price in a spot transaction. Would you expect the price of bananas to be the same in Helsinki as in Honduras? No. These prices would differ because the trades would occur at different points on the globe. An FX forward trade will generally involve a different price than a spot trade; these ...