What Is a Forward Exchange Contract (FEC)?

A forward exchange contract (FEC) is a unique over-the-counter (OTC) foreign currency transaction used to exchange currencies not frequently traded in forex markets. These may involve minor or blocked currencies that are otherwise inconvertible. When dealing with a blocked currency, it is referred to as a non-deliverable forward, or NDF.

Broadly speaking, forward contracts are agreements between two parties to exchange a currency pair at a predetermined future date. These transactions typically occur after the settlement date of a spot contract and serve as a safeguard against currency price fluctuations.

Key Takeaways

• A forward exchange contract (FEC) is a pact between two parties to conduct a currency transaction, often involving less commonly traded currency pairs.
• FECs are traded over-the-counter with flexible terms, often involving illiquid, blocked, or inconvertible currencies.
• FECs act as a hedge against risk, offering protection to both parties from unforeseen movements in future spot rates of currencies when traditional FX trading is not feasible.

Understanding Forward Exchange Contracts (FECs)

Forward exchange contracts (FECs) differ from standard exchanges as they are not traded on platforms, and fixed amounts of currency are not involved. These contracts cannot be terminated unless mutually agreed upon by both parties.

Parties entering into a FEC are typically looking to hedge forex positions or take a speculative stance. All FECs outline the currency pair, notional amount, settlement date, delivery rate, and require using the prevailing spot rate on the fixing date to finalize the transaction.

The exchange rate stipulated in the contract is fixed for a specific future date, aiding parties in budgeting for upcoming financial projects by knowing their income or costs in advance. The nature of FECs shields both parties from unexpected movements in future spot rates of currencies.

Forward exchange rates for most currency pairs can be secured up to 12 months ahead, and up to a decade for the primary pairs.

Typically, forward exchange rates are available for most currency pairs for up to 12 months. Major pairs, such as USD/EUR, USD/JPY, USD/GBP, and USD/CHF, can have exchange rates for up to 10 years.

Providers also offer contracts as short as a few days, but the full benefits of an FEC are usually realized with a minimum contract size of $30,000.

Special Considerations

The major forward exchange markets are prominent in the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), Brazilian real (BRL), and Russian ruble (RUB). Primary OTC markets are active in London, with significant activity also in New York, Singapore, and Hong Kong. Some nations, like South Korea, have limited onshore forward markets in addition to an active NDF market.

The most extensive FEC trading occurs against the U.S. dollar (USD). Other active markets include the euro (EUR), Japanese yen (JPY), and to a lesser extent, the British pound (GBP) and Swiss franc (CHF).

Forward Exchange Calculation and Example

Calculating the forward exchange rate for a contract involves four variables:

• S = current spot rate of the currency pair
• r(d) = domestic currency interest rate
• r(f) = foreign currency interest rate
• t = contract time in days

The formula for the forward exchange rate is:

Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360)

For instance, if the spot rate between the U.S. dollar (USD) and Canadian dollar (CAD) is 1 CAD buys $0.80 USD, with a three-month rate of 0.75% for USD and 0.25% for CAD, the three-month USD/CAD FEC rate can be calculated as:

Three-month forward rate = 0.80 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360)) = 0.80 x (1.0019 / 1.0006) = 0.801

The difference due to the rates over 90 days is one one-hundredth of a cent.