The two best qualities of a currency forward contract are its versatility in terms of general conditions, quantities and time frame as well as the fact that it requires virtually no down payment of any kind, so there are no standards set for this kind of derivative, unlike currency futures, the next closest thing. However, the very essence of Forex markets is linked to currency forward contracts, and here is how:
Forex market is not your average exchange office
There is a huge difference between how currencies are exchanged with the general public, on the streets, and the way they are quoted on a Forex market. Your local exchange office offers a fixed exchange rate for the day, and it rarely changes outside of regular schedule. This way, it doesn’t matter if you forgot to stop by this morning, since you can just exchange your currency on your way home; the exchange rate should be the same, right? Well, Forex markets do not normally work this way. Exchange rates vary every second or two, and every pip counts. Furthermore, due to the sheer volume of cash being exchanged, Forex traders could stand to lose a fortune in a single transaction, due to a sudden price change of a particular currency pair. Now mind you, these guys are not your average workers, looking to exchange $100 in order to get some spending money in some local currency, these guys mean business; we are talking about millions, and in this case every single pip matters. When found in this type of precarious position, you tend to minimize the risk, or even eliminate it completely, if you can. With a currency forward, a trader or a major player on Forex markets can ensure a favorable exchange rate in the next period, in order to lock in the profits.
Conclusion about Currency Forward Contract
However, this does not come without a price: currency forwards may essentially be hedging tools for the super rich, but they do come with their own share of risks and flaws. First of all, there is no clearing house to ensure everything goes as planned. Furthermore, you still need a counter party for this little arrangement. And if a bank or an institution is doing your forwards for you, they may still require a deposit and/or a margin even though they have no such responsibilities towards their counter parties. In other words, your bank doesn’t need to pay anything up front, but you do. And the best part is yet to come: most parties arranging currency forwards do not actually have the currency on them (if they did, wouldn’t they exchange it outright?). Rather, they expect to have it in due time. The thing is, currency forward derivative contracts are legally binding, so simple default is rarely an option. Plus, the exchange rates change all the time, and even if everything goes according to plan and you get the money, if the spot exchange rates are more favorable – tough luck.