Forward Exchange Contract (FEC): Definition, Formula & Example

What Is a Forward Exchange Contract (FEC)?

A forward exchange contract (FEC) is a special over-the-counter (OTC) foreign currency (forex) transaction that allows traders to exchange currencies that are infrequently traded. These may include minor currencies as well as blocked or otherwise inconvertible currencies. Forward contracts are agreements between two parties to exchange a pair of currencies at a specific time in the future. These transactions typically take place on a date after the spot contract settles and are used to protect the buyer from currency price fluctuations.

Formula and Calculation of Forward Exchange Contract (FEC)

The forward exchange rate for a contract can be calculated as:

Forward rate = S x (1 + r(d) x (t ÷ 360)) ÷ (1 + r(f) x (t ÷ 360))

Where:

• S = the current spot rate of the currency pair
• r(d) = the domestic currency interest rate
• r(f) = the foreign currency interest rate
• t = time of contract in days
  

Understanding Forward Exchange Contracts (FECs)

As noted above, FECs are OTC transactions that allow investors to trade currencies that aren't commonly traded in the forex market, including minor currencies and blocked or inconvertible currencies. An FEC involving such a blocked currency is known as a non-deliverable forward (NDF).

FECs are not traded on exchanges and they don't trade standard currency amounts. These contracts cannot be canceled except by the mutual agreement of both parties involved. The parties involved in the contract are generally interested in hedging a foreign exchange position or taking a speculative position.

All FECs set out the:

• Currency pair
• Notional amount
• Settlement date
• Delivery rate

They also stipulate that the prevailing spot rate on the fixing date be used to conclude the transaction. The contract's rate of exchange is fixed and specified for a specific date in the future. This allows the parties involved to better budget for future financial projects and be aware of their income or costs from the transaction ahead of time. The nature of FECs protects both parties from unexpected or adverse movements in the currencies' future spot rates.

Special Considerations

The largest forward exchange markets include the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), Brazilian real (BRL), and Russian ruble (RUB). The largest OTC markets take place in London, with active markets also in New York, Singapore, and Hong Kong. Some countries, including South Korea, have limited but restricted onshore forward markets in addition to an active NDF market.

The largest segment of FEC trading is done against the U.S. dollar (USD). There are also active markets using the euro (EUR), the Japanese yen (JPY), and, to a lesser extent, the British pound (GBP) and the Swiss franc (CHF).

Forward Exchange Rates

Forward exchange rates for most currency pairs can be obtained for up to 12 months in advance. There are four pairs of currencies known as the major pairs. These are the:

• U.S. dollar and euro (USD/EUR)
• U.S. dollar and Japanese yen (USD/JPY)
• U.S. dollar and the British pound sterling (USD/GBP)
• U.S. dollar and the Swiss franc (USD/CHF)

Exchange rates can be obtained for a period of up to 10 years for these pairs. Contract times as short as a few days are also available from many providers. Although a contract can be customized, most entities won't see the full benefit of an FEC unless setting a minimum contract amount at $30,000.

Example of Forward Exchange Contract (FEC)

Here's a hypothetical example to show how FECs work. Let's assume that the U.S. dollar and Canadian dollar (CAD) spot rate is $1 (CAD) buys $0.80 (USD.) The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. In this case, the three-month USD/CAD FEC rate would be calculated as:

Three-month forward rate = 0.80 x (1 + 0.75% x (90 ÷ 360)) ÷ (1 + 0.25% x (90 ÷ 360)) = 0.80 x (1.0019 ÷ 1.0006) = 0.801

The difference due to the rates over 90 days is one one-hundredth of a cent.

The Bottom Line

The foreign exchange market is the most liquid and largest one in the world. So, it should come as no surprise that there are different nuances to this market. Forward exchange contracts are special contracts that trade over the counter. Investors can use these contracts to trade currency pairs that aren't very common. These contracts can be somewhat complex, which is why novice traders should do their homework before considering anything like them. Doing your research can help you minimize your losses and avoid investment shock.