Forward Exchange Rate to Provide Protection Against Foreign Exchange Risk Nobody enters in forex market with the aim to lose money thus the two main pillars of forex: forward exchange rates (also known as forward rates) and spot rates hedge the currency transaction from the negative movements of the market. In earlier days, forex was limited to big corporate giants only and for them currency hedging was the first priority and then comes the point of gaining profit. Any international currency exchange transaction is either done using spot rates or forward exchange rates. These two types of rates divide the whole forex market into two different segment. In the spot rates segment, the purchase and sale of currency is done within two days only. And in the forward exchange rates segment the contract is created where the exchange rate for future delivery date is decided. The time may vary from 1month,2month,3month or more than that depending on the size and type of transaction. The time taken to make delivery of the payment is known as the maturity or expiry time and the date on which payment is completed is known as maturity date. Forward exchange rates were introduced with the purpose of covering businesses or individuals from the forex market risk. However, forward rates are widely used for currency speculation today. In the forex terminologies, forward rates are often quoted as premium or discount. What's the difference between the premium rates and discount rates? If the currency is at the premium rate then it is more expensive to buy forward than to buy spots and if it is quoted as discount then less expensive to buy forward than to buy spot. To know whether the forward rate is at premium or discount, we just need to compare them with the spot rate (live rate). If the forward rate offered by the forex broker is higher than the spot rates than it is quoted as forward at premium. And if the spot rate is higher than forward rate then it is quoted as forward at discount. To fix forward rate, interest rate offered by the particular country also plays role. There is one basic theory behind all these mathematics which is known as interest rate parity theory. This may seems confusing but to understand the basic difference between these most frequently used forex quotes, we will take one simple example. Say X company from US buys england securities in ÂŁ1 million with the maturity time of 3 months. Here, X company from US has to make payment in sterlings on a fix future date. Suppose as per the current rate 1GBP=$1.71. Over the next 3 month sterling may rise against greenback but by choosing forward rate the X company has hedge its transaction. The forward rate offered to X company is say $1.72. After 3 months the forex company will give ÂŁ1 million to the US company at the rate of $1.72. Thus, the US company will be actually paying $1.72 million. It may possible that after 3 months the spot rate of forex were higher than the offered forward rate $1.72. Say the spot rate of the market were $1.74 at the time of payment which means that you have got forward at discount. And if the spot rate of market were $1.70 then you have got forward at premium. Currency rate movement in forex is quite uncertain thus it is advisable to choose currency hedging while making international transaction.
The definition of forward exchange rates and spot rates and example illustrating the difference of premium and discount forward rate.