A currency forward contract is an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.
By using a currency forward contract, the parties are able to effectively lock-in the exchange rate for a future transaction.
The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations.
The currency forward contracts can be both deliverable or cash settled. In case of cash settled currency forwards the payment is made by the party who is at loss to the party who is at gain.
Let’s take an example to understand how a currency forward contract works.
Assume a US exporter who is expecting to receive a payment of EUR 10million after 3 months. Since he will need to convert these euros into US dollar, there is exchange rate risk involved. The exporter enters into a cash-settled currency forward contract to exchange 10 million euros into US dollars after 3 months at a fixed exchange rate of 1EUR = 1.2 USD. That means he will be able to exchange his 10 million euros for 12 million US dollars after 3 months.
Now assume that the actual exchange rate after 3 months is 1 EUR = 1.18 USD.
If there were no forward contract, the exporter would have received USD 11.8 million by exchanging EUR 10 million at the market exchange rate.
Since there is a forward contract, the exporter should receive USD 12 million at the rate of 1 EUR = 1.2 USD.
Under the terms of the contract, the counterparty must compensate the exporter by making a payment equivalent to the difference between the fixed rate and the current exchange rate to the exporter. In this case, the exporter will receive USD 0.2 million from the counterparty as cash settlement.
Note that if the US dollar has strengthened instead of weakening, then the exporter would have made the payment to the counterparty.