Exchange rate is not always stable, it keeps on changing every three seconds, therefore by the time exporter or importer has executed the contract and realized his bill, exchange rate might have turn adverse for him bringing unexpected losses to him.
To overcome this risk forward contract can be used, which is defined as a contract which is entered by two parties for purchase or sale of foreign currency at an agreed rate at a future date. The rate specified in forward contract is called forward rate. Here are some of the features of forward exchange contract –
1. Forward rate for a currency is not equal to spot rate, it may at premium that is higher or at discount that is lower than spot rate.
2. The premium and discount on forward rate in a free market will be equal to the differences between interest rates in the two currencies.
3. A forward contract has no secondary market, it is written over the counter to suit the specific exposure requirement of the clients of the banks.
4. Apart from demand and supply of currency there are other factors like sudden movements in capital, activities of speculators, intervention by the central banks in foreign exchange market which influences the forward rates.
5. Forward exchange contracts can either be fixed forward contract or option forward contract. Under fixed contract the transactions will have to be completed on the specified forward date, while under option contract the transactions will have to be completed within a specified period and not on specified date which cannot exceed one calendar month.