Also known as a forward rate, a forward exchange rate is the price or rate that is quoted by a seller on the current date and accepted by a buyer on that same date, allowing the two parties to initiate a trade. Rather than requiring payment and delivery at that time, the two parties determine a schedule that allows for the payment and the delivery to be completed on a specified future date. This arrangement allows both parties to enter into transactions that will ultimately benefit both parties.
There is sometimes confusion between what is meant by a spot exchange rate and a forward exchange rate. It is true that both rates have to do with the pricing as it relates to the actual date that the buyer and seller decide to enter into a transaction. The difference is the time frame that is allowed for settling that transaction. For example, if the buyer and seller agree to a price and a delivery date that is within two business days of the initiation of the trade, then that is considered to be a spot exchange. If those two parties should agree that the payment and delivery will occur 30 calendar days from the date that the exchange is initiated, then the rate involved would be considered a forward exchange rate.
One of the benefits for the buyer of entering into a trade involving a forward exchange rate is the ability to lock in the lower pricing of today but defer payment until a time when the value of the assets acquired has increased. For example, the buyer may purchase an even lot of stocks for $10 US dollars per share, with an agreement to take possession and pay for those shares on a specific date the following calendar month. Assuming those shares of stock appreciate in value in the interim to a rate of $15 USD per share, the buyer can arrange to sell the shares at the higher rate and deliver them after taking possession and paying the original seller. The end result is generating a profit of $5 USD per share on the exchange.
While a forward exchange rate strategy is often a great way to generate additional revenue from buying and selling stocks, there is some degree of risk involved. Should the stocks fail to perform as projected, there is always the chance that the market value of the shares will fall below the exchange rate agreed upon between the buyer and seller. When this happens, the buyer is still often bound to honor the agreement and pay for the shares on the appointed date, and will incur some amount of loss. For this reason, it’s a good idea to always consider all relevant factors when projecting the future movement of stock prices and to take that into consideration before locking in a forward exchange rate for the purchase of any type of asset, whether it be stocks or even currency trades.
