For most business transactions, you know well in advance what you will need to buy or sell. The Forward market exists so that you can do a deal now at a known price for delivery at some time (usually month periods) in the future.
The forward foreign exchange agreement you will make with an institution is conceptually straightforward. It will be based on today’s spot rate, plus-or-minus the interest rate differential between the two currencies for the period forward.
If the currency you are buying has lower interest rates than the one you are selling, the forward rate will give you less of the currency than the spot rate – and vice versa.
A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customized to any commodity, amount and delivery date. A forward contract settlement can occur on a cash or delivery basis.
Another way to understand forwards is to realise that the bank is not taking any risk. They close out their positions at least once each day, often more often. They do that by effectively buying or selling the currency today and investing the foreign funds for the time period at that interest rate. On the forward date they (or you) will deliver the agreed amount (original spot plus-or-minus the difference between the interest earned/cost of each currency). It’s a spot transaction plus the holding costs to the delivery date.
This is an effective way to lock in a foreign currency transaction for a future date at a known cost, using the bank’s wholesale access to interest rates in each currency. (It’s not your access to the foreign money market rates; it’s the bank’s access that makes this work.)
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