A foreign exchange forward contract is a binding agreement to exchange specified amounts of two currencies on an agreed future date at an exchange rate fixed today. It lets a business fix the currency cost of a future payment or the proceeds of a future receipt. The commitment remains if the exchange rate later moves in the business's favour.
An outright FX forward has one future exchange. A foreign exchange swap combines exchanges in opposite directions on different dates. Here the focus is a single-date, deliverable forward contract: both currencies actually change hands. The ECB glossary describes the exchange agreed now for later delivery; the exact value date and settlement instructions belong in the trade terms.
Write the currencies before calculating
Consider a fictional one-year forward to buy EUR100 and pay USD122. The fixed delivery rate is USD per EUR. In market pair notation this is EUR/USD: EUR is the base currency, and USD is the quote currency. The pair label EUR/USD and the dimensional units USD per EUR follow different ordering conventions; writing the units prevents an accidental inversion.
Stipulate that 1.22 is the initial market forward rate, consistent with the two currencies' funding terms, so this clean contract starts at zero market value. No currencies or premium change hands at entry in this example. It excludes fees, collateral flows, funding costs and default, and has only the maturity exchange. A real transaction's collateral, charges and documentation can create earlier cash requirements. An off-market delivery rate may require an upfront payment.
The USD122 is the future delivery payment, not today's price of the contract. The rate 1.22 is also not a prediction of the spot rate in one year. Under a frictionless funding model, covered interest-rate parity connects spot, forward and both currencies' interest rates. A forward quote alone does not identify the future spot outcome.
Delivery and economic value are different ledgers
Suppose the spot rate at maturity is 1.30 USD per EUR. The buyer still pays USD122 and receives EUR100. Those euros are now worth USD130, giving an economic maturity value of +USD8:
where is the EUR amount and is measured in USD per EUR. The units cancel correctly: EUR multiplied by USD per EUR gives USD. The seller of EUR has the opposite economic value, before costs and default.
Original synthetic deliverable-forward ledger. All valuation amounts are USD; rates are USD per EUR. Zero entry value is stipulated, and fees, collateral flows, funding costs and default are excluded.
The buyer does not receive an additional USD8 alongside the euros. That number marks the advantage of exchanging under the contract rather than at the maturity spot rate. If the buyer converts the received EUR100 immediately into USD130 at that spot rate, the two exchanges leave USD8 before costs. If the euros are used to pay a supplier, there is no such resale.
| Maturity spot, USD per EUR | Value of EUR100 received, USD | USD paid under the contract | Economic maturity value, USD |
|---|---|---|---|
| 1.30 | 130 | 122 | +8 |
| 1.22 | 122 | 122 | 0 |
| 1.10 | 110 | 122 | −12 |
In the last row, buying the euros at spot would have cost less. The forward buyer must nevertheless perform; a forward does not give the right to walk away as an option can.
The hedge is the payment plus the forward
Suppose the buyer owes a supplier exactly EUR100 on the forward's delivery date. The forward provides those euros for USD122, and the supplier payment uses them. The combined position has zero remaining EUR cash flow and a fixed USD122 outflow, whether maturity spot is 1.30 or 1.10 USD per EUR.
A negative standalone forward value can therefore coexist with a successful hedge. The purpose was to fix the USD cost, not to outperform whichever spot rate happened to occur. If the invoice is cancelled or its amount or date changes, the original forward remains and can leave unwanted currency exposure. The hedge also requires the counterparty to deliver and the buyer to fund its USD payment.
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Before delivery, the old rate stays fixed
Three objects must stay separate:
| Object | Units | What it represents |
|---|---|---|
| USD per EUR | Fixed rate in the existing agreement | |
| USD per EUR | Current rate for a new zero-value forward with the same delivery date | |
| USD | Current value of the existing EUR-buying position |
In the clean model with matched terms and a USD discount factor ,
For a separate pre-maturity illustration, suppose a new matching forward quotes 1.26 USD per EUR, and the USD discount factor to the original delivery date is 0.98. Selling EUR100 forward at the new rate would offset the original EUR purchase, locking in USD4 at delivery: . Its present value is USD3.92, since . The old remains 1.22. This valuation does not use the separate maturity scenario's spot rate of 1.30.
An offsetting trade locks future cash flows; it does not by itself terminate the original contract or pay out today's value. Actual closeout values depend on executable quotes, collateral, credit and funding terms. Contract profit also needs those cash flows and costs; it cannot be read from the fixed delivery rate alone.
Settlement method changes what must be funded
A deliverable FX forward requires both currency payments. The buyer in the main example must arrange USD122, even though the marked economic advantage is only USD8. Failure to receive the bought currency after paying the sold currency creates principal settlement risk. BIS explains how payment-versus-payment arrangements link the finality of the two legs and mitigate that risk; their availability and suitability depend on the trade and participants.
A non-deliverable forward instead settles a difference in a specified currency using an agreed fixing and contractual calculation. It does not itself deliver the foreign currency needed for a supplier payment. The BIS discussion of NDFs makes this funding distinction explicit. Do not transplant the simple USD-per-EUR formula above into a differently quoted NDF without checking its notional currency, fixing and settlement formula.
Practice: a receipt reverses the hedge direction
A USD-reporting exporter will receive GBP200 on an agreed future date. It wants to fix its USD receipt at a fictional forward rate of 1.28 USD per GBP. Should it buy or sell GBP forward? If maturity spot is 1.35 USD per GBP, what are its hedged USD receipt and the forward's standalone economic maturity value? Ignore costs, collateral and default; match the receipt and delivery date exactly.
Answer. Sell GBP200 forward and receive USD256, because . The customer receipt supplies the GBP for delivery. At spot, those pounds would be worth USD270, so the short-GBP forward's economic maturity value is −USD14: . The combined cash receipt is still USD256. Buying GBP forward would add to the exporter's GBP exposure instead of offsetting it.
Sources
- John C. Hull, Options, Futures, and Other Derivatives, ninth Global Edition, Pearson, 2018, §5.7, pp. 134–136, and §5.10, pp. 139–141: delivery rate versus contract value, offsetting forwards and the two-currency funding relation.
- European Central Bank, glossary: foreign exchange forward and foreign exchange swap: instrument definitions.
- BIS, “FX settlement risk: an unsettled issue”, December 2022: deliverable settlement and payment versus payment.
- BIS, “Non-deliverable forwards: 2013 and beyond”, March 2014: difference settlement and the absence of delivery funding in the underlying currency.