What is the definition of a forward exchange contract (FEC)?
A forward exchange contract (FEC) is an OTC forex transaction that swaps currencies not commonly traded in forex markets. These may include minor and inconvertible currencies. A blocked cash FEC is a non-deliverable forward (NDF).
Forward contracts are agreements between two parties to exchange currency for a particular period. These transactions insulate buyers against currency price swings, often occurring after the spot contract settles.
Forward Exchange Contracts Overview
Not traded on exchanges, forward exchange contracts (FECs) do not include conventional quantities of currency. Both parties must agree to cancel them.
The parties participating in the contract typically seek to hedge or speculate on foreign exchange positions. All FECs state the currency pair, notional amount, settlement date, delivery rate, and usage of the spot rate on the fixing date.
Fixed and set for a given date, the contract’s exchange rate allows parties to better budget for future financial initiatives and know in advance their revenue or expenditures from the transaction. FECs safeguard both parties from unexpected or negative currency spot rate changes.
Forward exchange rates for most currency pairings are typically available for 12 months or up to 10 years for the four “major pairs.”
Forward exchange rates for most currency pairings are typically available for up to 12 months. Four currencies are the “major pairs.” These include the U.S. dollar and euros, the Japanese yen, the British pound sterling, and the Swiss franc. Up to 10-year exchange rates are available for these four pairings.
Many carriers offer contracts as short as a few days. Most entities won’t profit from an FEC unless they set a minimum contract amount of $30,000.
Special Considerations
CNY, INR, KRW, TWD, BRL, and RUB are the major forward exchange markets. New York, Singapore, and Hong Kong have active OTC markets, but London has the largest. Certain nations, such as South Korea, have restricted onshore forward markets in addition to an active NDF market.
Most FEC trading is against the USD. The Euro (EUR), Japanese yen (JPY), British pound (GBP), and Swiss franc (CHF) markets are also active.
Forward Exchange Formula and Example
- Four variables determine a contract’s forward exchange rate:
- S = currency pair spot rate
- r(d) = domestic currency interest rate
- Foreign currency interest rate (r)
Contract time in days
Forward exchange rate formula:
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x).
Consider a spot rate of 1 CAD to USD 0.80. The three-month U.S. rate is 0.75%, while the Canadian rate is 0.25%. The three-month USD/CAD FEC rate would be:
Three-month forward rate = 0.80 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% *) = 0.80 x (1.0019 / 1.0006) = 0.801
Rate differences over 90 days are one-hundredth of a penny.
Conclusion
- A forward exchange contract (FEC) is a two-party agreement to trade a currency pair not available on FX markets.
- OTC FECs sometimes reference illiquid, banned, or inconvertible currencies and have configurable terms.
- FECs safeguard both parties against unexpected or undesirable currency spot rate changes when FX trading is absent.
