Forwards are the most commonly used technique for the hedging of foreign currency exposure especially by exporters and importers. There are forward markets in for the most major currencies of the world. A forward exchange contract has been defined by Winstone (1995) as; an immediately firm and binding agreement between bank and customer to buy or sell an agreed amount of currency at a rate of exchange fixed at the time when the contract is made for performance by delivery of and payment for the stated amounts on or between two specified future dates.

Forward rates are determined in the market but are not an estimation or prediction, of what spot rates will be in the short-term future. In brief, they are determined by the interest rate differential between the two currencies concerned.

The currency with the higher interest rate is always at a discount in the forward market. In other words, the currency with the lower interest rate is at a premium in the forward market. Therefore, the forward price, either a premium or discount, is always closely tied to the difference of interest rates in the two currencies. If the deal is transacted with other than a substantial bank, the element of fulfilment, the risk that the counterparty will not meet his obligation at maturity, must be considered.

A numerical example which is quoted from Buckley (1986) may better explain the practices of forward contracts.

On 28 September 1984, a UK company enters into an export contract with a French company. Goods are shipped, invoiced at Ff 5 million and the credit term is determined for two months as summarised below:

Source: Buckley (1986)

On date of contract exchange rate was Ff11.531=£1 at the spot market. The receivable is booked at mentioned rate, giving a sterling equivalent of £433,614. However, the UK company will actually receive the Ff 5 million on 28 November 1984. Therefore, the treasurer of the UK company, simultaneously with the signing of the export contract, gives an order to the banker to sell Ff 5 million in the forward exchange market at a fixed price for delivery on the receivable date of payment. Exchange rate quotes for both spot and forward markets are given in the following table.

Source: Buckley (1986)

The fixed price will be the two-month forward rate for selling French francs and buying sterling. As seen from the table, this rate is Ff 11.546. By this forward contract, the UK exporter has contracted to deliver Ff 5 million in two months at the forward rate of Ff 11.546=£1.

Source: Buckley (1986)

After this transaction, whatever happens to the franc/sterling spot and forward rates over the next two months, the contracted forward rate is irrevocably fixed.

Source: Buckley (1986)

On 28 November 1984 the UK company should receive the French importer’s payment of Ff 5 million. This is then delivered to the bank handling the forward deal and as agreed in the forward contract, the British exporter receives a sterling credit of £433,050.

On the other side, in case of bad debt risk, for example French company fails to pay or goes bankrupt, the UK company may buy bad debt insurance through such agencies.

However, in such cases, settlement date may not be known certainly. The exporter may decide to cover this uncertain payment through a forward option. It is different from a currency option contract. As in all forward contracts, exchange rate is fixed irrevocably when the contract is made. However, precise maturity date which should be within a specified option period is open in a forward option contract. Since the bank is giving the option, does not know when the option will be taken up, and will charge the premium or discount for the most costly of the settlement sales within the customer’s option period.