A forward contract binds two parties to exchange an agreed amount of one currency for another at a fixed rate on a specified future date. A forward rate is calculated by taking spot and adding or subtracting forward points. Spot is the price today to sell one currency and buy another with settlement in one business day. Forward points are determined by the currencies’ interest rate differentials. If the base (denominator) currency’s interest rates are higher, forward points will be negative and the forward rate will be priced at a discount. Conversely, if the base currency’s (denominator) interest rates are lower, forward points will be positive and the forward rate will be priced at a premium.
Benefit
- Provides a hedge against a USD depreciation
- Can determine exchange rate today for the future cash flow
Drawback
- Provides no opportunity to benefit from a possible USD appreciation
- Creates an obligation and market risk will exist if FX payments change
Implied View
- View that USD/CAD will depreciate
- Preference for a fixed structure
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