Foreign exchange forward
Also written FX forward · Currency forward · Outright forward contract · OTC currency forward · Forex forward
An OTC derivative involving the exchange of two currencies on a specified future date more than two business days away, at a rate agreed on the date of the contract.
In plain language
An exporter will be paid in dollars in three months. He wants to know today what those dollars will be worth in rupees.
His bank can tell him. It quotes a rate for a deal that settles in three months, and both sides are bound to it. That is a foreign exchange forward.
The workbook's definition is short: an OTC derivative involving the exchange of two currencies on a specified date in the future — more than two business days later — at a rate agreed on the date of the contract.
Notice the "more than two business days". Two business days is the spot date. Anything settling after it is forward. Anything on or before it is not.
Two more features matter.
It is over the counter. The bank and the customer negotiate every term between themselves, so the amount and the date can match the exposure exactly.
And it is settled by delivery. The workbook says the settlement of forward contracts is mainly physical, with actual exchange of currencies. This is where it parts company with an exchange traded future, which is cash settled.
A plain forward with a single future date is called an outright forward contract.
How it works
The definition and its boundary (Chapter 2, section 2.3.1). A foreign exchange forward means an OTC derivative involving the exchange of two currencies on a specified date in the future (more than two business days later) at a rate agreed on the date of the contract. The generic forward definition in the same section adds that both contracting parties are committed and obliged to honour the transaction irrespective of the price of the underlying at the time of delivery, that terms are customised because the contract is negotiated between two parties, and that generally no initial margin or mark-to-market margin is collected.
How the tenors are counted (Chapter 1, section 1.3.10). Any settlement date after the spot value date is a forward value date, and forward dates are standardised into 1-month, 2-month and so on after the spot value date — not after the trade date.
Liquidity and settlement.
| Feature | What the workbook says |
|---|---|
| Quotable maturities | The forward OTC market can provide quotes for any maturity |
| Where liquidity sits | Higher for maturities less than one year; it declines beyond one year |
| Settlement | Mainly physical, with exchange of actual currencies |
| Contrast with futures | Futures prices are available for month-end maturity contracts and settlement is always on a net settlement basis |
The market plumbing.
- CCIL settles interbank cash, tom, spot and forward USD-INR transactions through multilateral netting, and offers CCP services with trade guarantee for USDINR forward contracts and USDINR swap contracts.
- Forex trading in India takes place OTC, including on electronic trading platforms, for spot, forward and swaps, while futures are traded on exchanges — NSE, BSE and MSEI. Options trade both OTC and on exchanges.
- In forex forwards, volumes typically increase gradually during the day, with the last two hours having relatively higher volumes — unlike spot, which is well distributed through the day.
- FBIL announces benchmark USD-INR Forward Premia rates for Overnight and from 1 month to 12 months, daily except Saturdays, Sundays and public holidays, based on USD/INR transaction data reported up to 3 pm on the CCIL platform.
The limitations that produced the futures contract. Chapter 2, section 2.6, sets the OTC forward against the exchange traded contract. An OTC derivative is privately negotiated and settled between two parties, which makes the exchange traded contract more transparent. An OTC contract carries counterparty credit risk — failure of the counterparty before the settlement date — and settlement risk — default on the settlement date; neither arises in an exchange traded derivative, because of the trade guarantee given by the Clearing Corporation as central counterparty through novation. And the exchange traded market can offer a hedging solution even to small size requirements, whereas in the OTC market hedging a very small requirement may not be possible, or the transaction cost may be prohibitive. Chapter 3, section 3.5, adds that OTC contracts have low liquidity, because a tailor-made contract is not easily accessible to other market participants, are settled gross, without netting, and that less information is available in the public domain — mainly post-trade. Its one advantage stands: a customised contract can provide a perfect hedge.
A worked example
The workbook's worked forward. XYZ has exported cashews to the US. The shipment is worth USD 5,000,000, due after 3 months. Spot USDINR is 75.10. XYZ enters a forward with its bank to realise the proceeds after 3 months at INR 75.80 per dollar, which becomes the forward rate for that transaction.
| Item | Figure |
|---|---|
| Receivable | USD 5,000,000 |
| Spot on the trade date | 75.10 |
| Contracted forward rate | 75.80 |
| Rupees assured | 5,000,000 x 75.80 = Rs 37.90 crore |
What the cover does for XYZ, in the workbook's own four points:
| Scenario at maturity | Outcome |
|---|---|
| Rupee appreciates to 74.50 | No worry — the rate of 75.80 is already locked |
| Rupee unchanged at 75.10 | Same — locked at 75.80 |
| Rupee weakens beyond 75.80 | A notional loss, because XYZ could have got more in the market |
| Cash flow planning | XYZ is confident the inflow will cover its payables, with minimum risk of cash flow uncertainty |
That third row is the honest part. A forward removes the bad outcome and the good one together.
A second, smaller case (Chapter 1, section 1.3.10). An Indian company expects EUR 1,000 from an export order after one month. On the trade date it agrees to sell EUR 1,000 and receive INR 84,000 after one month — a forward-1 month rate of 84.00 to the euro. On the maturity date it delivers EUR 1,000 and receives INR 84,000. That is an outright forward contract.
Where the tenor is counted from. The company trades on a Monday.
| Date | Meaning |
|---|---|
| Monday | Trade date |
| Wednesday | Spot value date, T+2 |
| One month after Wednesday | The 1-month forward value date |
Counting the month from Monday is wrong, and it is the sort of slip that shifts a hedge past the day the money lands.
Why NISM asks about it
Chapter 2, section 2.3.1 (Forwards), carries the definition and the cashew-export illustration; Chapter 1, section 1.3.10, gives the forward value date, the standardised tenors and the EUR 1,000 outright forward; section 1.3.3 places forwards in the OTC segment and futures on the exchanges. Chapter 3, section 3.5, contrasts forwards with futures point by point, and that comparison table is heavily examined. The likeliest question is the "more than two business days later" boundary, or which of a listed set of products trades OTC rather than on an exchange.
Common exam traps
- More than two business days later. A contract settling on or before the spot date is not a forward.
- Forward tenors run from the spot value date, not from the trade date.
- Settlement is mainly physical, gross and without netting. Exchange traded currency futures are cash settled on a net basis — the opposite.
- Generally no initial or mark-to-market margin on a forward. Margins and daily mark-to-market belong to futures.
- Both parties are obliged. A forward is not an option; there is no right to walk away.
- Liquidity is higher under one year and declines beyond it, even though quotes are available for any maturity.
- CCIL offers CCP services with trade guarantee for USDINR forwards and swaps — so do not answer that OTC forwards in India have no central clearing at all. The workbook explicitly records this exception.
- The FBIL forward premia benchmark covers overnight and 1 to 12 months, computed from CCIL data up to 3 pm.
Check yourself
1.A USDINR contract settles on T+2. Under the derivative criteria, this contract:
- a)Is a derivative because it settles in the future
- b)Is not a derivative — the settlement of a derivative must be later than that for the underlying, and USDINR spot itself settles T+2
- c)Is a derivative only if margin is collected
- d)Is a derivative because no full cash outlay is required on trade date
Show the answer
Answer: (b) Is not a derivative — the settlement of a derivative must be later than that for the underlying, and USDINR spot itself settles T+2
The "future" date in the second requirement means that the settlement of the derivative must be later than that for underlying. For example, if the underlying settles on two business days after trade date (T+2), the derivative on that underlying must settle later than T+2; if the underlying settles in T+5, the derivative on that underlying must settle later than T+5; and so on.
Later than the underlying's own settlement — not merely later than today.
Since USDINR spot is the settlement after two business days, a T+2 contract is simply a spot trade.
Options A and D each pick one criterion and ignore the others. All three must hold: 1. Value of derivative is linked to the value of underlying. 2. Trade settled on a "future" date. 3. On trade date, there should be no full cash outlay.
Option C invents a requirement. Margin is a feature of exchange-traded products — generally, no initial margin or mark-to-market margin is collected for forwards, which are derivatives all the same.
The rule is written into the legal definitions. A 'Foreign exchange forward' means an OTC derivative involving the exchange of two currencies on a specified date in the future (more than two business days later) at a rate agreed on the date of the contract.
And the statutory definition says the same: a foreign exchange derivative contract is for settlement at a future date, i.e. any date later than the spot settlement date.
Under FAS 133 there is a fourth criterion: trade must settle (or capable of being settled) on net basis and not on gross basis — which IAS 39 and AS 30 do not require.
2.Which of the following is listed as an advantage of currency futures over foreign exchange forwards?
- a)Delivery-based settlement, which helps importers and exporters
- b)Access to futures contracts does not depend upon the credit profile of the participants
- c)The ability to provide a perfect hedge through customisation
- d)Fewer operational issues related to margin and mark-to-market
Show the answer
Answer: (b) Access to futures contracts does not depend upon the credit profile of the participants
The futures advantages listed are: price transparency · elimination of Counterparty credit risk as settlement guarantee is given by the clearing corporation of Exchanges · access to all types of market participants · access to futures contracts does not depend upon the credit profile of the participants · lower liquidity risk compared to forwards · generally lower impact cost · easy entry and exit.
The credit-profile point is the one most easily overlooked. A bank chooses whether to extend a forward line; the exchange does not, because the clearing corporation guarantees every trade.
Options A, C and D are all forward advantages, listed on the other side of the table: can provide perfect hedge as it is a customized product · delivery-based settlement more helpful to importers and exporters · less operational issues related to margin and mark-to-market settlement.
Indeed the mirror images appear as futures limitations: may lead to imperfect hedge as the contract size and settlement dates are standardized · since it is cash settled, users need to access cash/spot market for actual delivery of currency · operational issues related to mark-to-mark settlement and margin.
The chapter's summary of the trade-off: futures have some distinct advantages over forward contracts as they eliminate counterparty risk and offer more liquidity and price transparency. On the other hand, forwards enjoy the benefit of being customized to meet specific client requirements.
And why the two are confused at all: both serve essentially the same economic function of hedging risk in the face of price uncertainty in the future.
Forward limitations, for completeness: liquidity risk · counter party risk · limited market participants · cancellation and rebooking are based on certain conditions.
3.Which of the following does the workbook list as a limitation of foreign exchange forwards (not futures)?
- a)Cancellation and rebooking are based on certain conditions
- b)May lead to imperfect hedge as the contract size and settlement dates are standardized
- c)Operational issues related to mark-to-market settlement and margin
- d)Users need to access the cash/spot market for actual delivery of currency
Show the answer
Answer: (a) Cancellation and rebooking are based on certain conditions
Forward limitations: "Liquidity risk · Counter party risk · Limited market participants · Cancellation and rebooking are based on certain conditions."
The other three are futures limitations:
- "May lead to imperfect hedge as the contract size and settlement dates are standardized."
- "Since it is cash settled, users need to access cash/spot market for actual delivery of currency."
- "Operational issues related to mark-to-mark settlement and margin."
The pattern: each product's limitation is the mirror of the other's advantage. Forwards are customised (perfect hedge, delivery) but carry counterparty and liquidity risk; futures are standardised (liquid, guaranteed) but hedge imperfectly and need margins.
Where this is taught
Free preparation for NISM Series IRelated terms
- Cash and tomThe two pre-spot settlement dates in the FX market: cash (or ready) settles the same day, tom settles the next business day, and both their rates are derived from the spot price rather than traded.
- Currency futuresA standardised exchange-traded contract to buy or sell one currency against another on a future date at a price fixed today; in India, cash-settled in rupees, USD 1,000 a lot for USDINR.
- Foreign exchange derivative contractUnder the FEMA regulations, a financial contract that derives its value from a change in the exchange rate of two currencies, at least one of which is not the rupee, and settles later than the spot date.
- Foreign exchange swapAn OTC derivative in which two currencies are actually exchanged on one date (the short leg) and re-exchanged at a later date (the long leg), at rates agreed at the time of the contract.
- Forward contractA bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
- Non-deliverable forwardA cash-settled, usually short-term currency forward in which the notional amount is never exchanged — only the difference between the contracted rate and the reference rate changes hands.
- Spot value dateThe settlement date of a standard spot FX deal — the second business day after the trade, provided both currency centres are open; earlier dates are cash (T) and tom (T+1).
- CCILThe Clearing Corporation of India Ltd, the central counterparty that guarantees settlement of government securities, repo and OTC interest rate derivative trades by novation.
- Currency swapAn OTC derivative in which two parties exchange streams of interest payments and/or principal in different currencies on set dates over the swap's life, at an exchange rate agreed at the start.
- Counterparty credit riskThe risk that the other party to an OTC derivative fails before the settlement date. It does not arise in exchange-traded derivatives, where the clearing corporation becomes central counterparty.