CURRENCY FORWARD CONTRACTS

Spurred by the relaxation of government controls over the exchange rates of most major currencies in the early 1970s, a currency forward market developed and grew extremely large. Currency forwards are widely used by banks and corporations to manage foreign exchange risk. For example, suppose Microsoft has a European subsidiary that expects to send it €12 million in three months. When Microsoft receives the euros, it will then convert them to dollars. Thus, Microsoft is essentially long euros because it will have to sell euros, or equivalently, it is short dollars because it will have to buy dollars. A currency forward contract is especially useful in this situation, because it enables Microsoft to lock in the rate at which it will sell euros and buy dollars in three months. It can do this by going short the forward contract, meaning that it goes short the euro and long the dollar. This arrangement serves to offset its otherwise long-euro, short-dollar position. In other words, it needs a forward contract to sell euros and buy dollars.
For example, say Microsoft goes to JP Morgan Chase and asks for a quote on a currency forward for € 12 million in three months. JP Morgan Chase quotes a rate of $0.925, which would enable Microsoft to sell euros and buy dollars at a rate of $0.925 in three months. Under this contract, Microsoft would know it could convert its €12 million to 12,000,000 X $0.925 = $1 1,100,000. The contract would also stipulate whether it will settle in cash or will call for Microsoft to actually deliver the euros to the dealer and be paid $11,100,000. This simplified example is a currency forward hedge, a transaction we explore more thoroughly in next posts.
Now let us say that three months later, the spot rate for euros is $0.920. Microsoft is quite pleased that it locked in a rate of $0.925. It simply delivers the euros and receives $1 1,100,000 at an exchange rate of $0.925.” Had rates risen, however, Microsoft would still have had to deliver the euros and accept a rate of $0.925.