The forward contract is a straightforward currency hedging tool. It effectively
allows you to buy or sell a foreign currency at today's market price, while delaying
the settlement of the contract to some future point in time of your choosing. To
compensate for the delayed settlement of the FX trade, the price of the forward
is calculated by adjusting for the time value of money; a concept that states a
dollar today is worth that much plus interest in the future. An adjustment, called
the forward points, is applied to the spot price to compensate for the interest
rate differential between the two currencies in question with the passage of time.
A forward is no different than a standard currency trade except that the settlement
date is pushed forward into the future and the rate is adjusted slightly to account
for the interest rate differential between the two currencies in question. When
you sell a currency with a low interest rate and buy a currency with a higher interest
rate in the forward market (as is presently the case when you sell USD and buy CAD),
you can obtain a forward price that is more favourable than can be achieved in the
The forward contract doesn't cost anything up front to book and provides you with
a predetermined rate of exchange for a specified amount of currency.
A forward contract has one downside: on the day of settlement you are obligated
to settle at the predetermined price. In exchange for this rate certainty, you forgo
the ability to participate in the spot market if the prevailing market rate is more
favourable than your predetermined forward rate.
The forward (exchange) rate is the rate at which the counterparties will execute
the future currency exchange. This rate is based solely on the interest rate differential
between the currencies. It is structured to eliminate any possible arbitrage opportunities
between the spot and interest rate markets.