Forward contracts are agreements between two parties to exchange two designated

currencies at a specific time in the future. These contracts always take place on a date after
the date that the spot contract settles, and are used to protect the buyer from fluctuations
in currency prices.
Forward contracts are not traded on exchanges, and standard amounts of currency are not
traded in these agreements. They 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. The contract's rate of exchange
is fixed and specified for a specific date in the future and allows the parties involved to better
budget for future financial projects and known in advance precisely what their income or
costs from the transaction will be at the specified future date. The nature of forward exchange
contracts protects both parties from unexpected or adverse movements in the currencies'
future spot rates.
Generally, forward exchange rates for most currency pairs can be obtained for up to 12
months in the future. There are four pairs of currencies known as the "major pairs." These are
the U.S. dollar and euros; the U.S. dollar and Japanese yen; the U.S. dollar and the British
pound sterling; and the U.S. dollar and the Swiss franc. For these four pairs, exchange rates
for time period of up to 10 years can be obtained. 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 a forward exchange contract unless setting a minimum contract
amount at $30,000.
Calculation Example
The forward exchange rate for a contract can be calculated using four variables:
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
The formula for the forward exchange rate would be:
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
For example, assume that the U.S. dollar and Canadian dollar spot rate is 1.3122. The U.S.
three-month rate is 0.75%, and the Canadian three-month rate is 0.25%. The three-month
USD/CAD forward exchange contract rate would be calculated as:
Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 / 360)) =
1.3122 x (1.0019 / 1.0006) = 1.3138

Foreign exchange hedge

A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to
eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign
currencies (see foreign exchange derivative). This is done using either the cash flow hedge or
the fair value method.
A foreign exchange hedge transfers the foreign exchange risk from the trading or investing
company to a business that carries the risk, such as a bank. There is cost to the company for
setting up a hedge. By setting up a hedge, the company also forgoes any profit if the
movement in the exchange rate would be favourable to it.
FOREIGN EXCHANGE RISK
When companies conduct business across borders, they must deal in foreign currencies.
Companies must exchange foreign currencies for home currencies when dealing with
receivables, and vice versa for payables. This is done at the current exchange rate between the
two countries. Foreign exchange risk is the risk that the exchange rate will change
unfavorably before payment is made or received in the currency . For example, if a United
States company doing business in Japan is compensated in yen, that company has risk
associated with fluctuations in the value of the yen versus the United States dollar.

A hedge is a type of derivative, or a financial instrument, that derives its value from an
underlying asset. Hedging is a way for a company to minimize or eliminate foreign exchange
risk. Two common hedges are forward contracts and options.
A forward contract will lock in an exchange rate today at which the currency transaction will
occur at the future date.[2]
An option sets an exchange rate at which the company may choose to exchange currencies. If
the current exchange rate is more favorable, then the company will not exercise this option.[2]
The main difference between the hedge methods is who derives the benefit of a favourable
movement in the exchange rate. With a forward contract the other party derives the benefit,
while with an option the company retains the benefit by choosing not to exercise the option if
the exchange rate moves in its favour.
Simple Forex Hedging
Some brokers allow you to place trades that are direct hedges. Direct hedging is when you are
allowed to place a trade that buys a currency pair and then at the same time you can place a
trade to sell the same pair.
While the net profit is zero while you have both trades open, you can make more money
without incurring additional risk if you time the market just right.

The way a simple forex hedge protects you is that it allows you to trade the opposite direction
of your initial trade without having to close that initial trade. It can be argued that it makes
more sense to close the initial trade for a loss and place a new trade in a better spot. This is
part of trader discretion. As a trader, you certainly could close your initial trade and enter the
market at a better price. The advantage of using the hedge is that you can keep your trade on
the market and make money with a second trade that makes profit as the market moves
against your first position. When you suspect the market is going to reverse and go back in
your initial trades favor, you can set a stop on the hedging trade, or just close it.
Complex Hedging
There are many methods for complex hedging of forex trades.
Many brokers do not allow traders to take directly hedged positions in the same account so
other approaches are necessary.
Multiple Currency Pairs
A forex trader can make a hedge against a particular currency by using two different currency
pairs. For example, you could go long EUR/USD and short USD/CHF.
In this case, it wouldn't be exact but you would be hedging your USD exposure. The only
issue with hedging this way is you are exposed to fluctuations in theEuro (EUR) and the
Swiss(CHF). This means if the Euro becomes a strong currency against all other currencies,
there could be a fluctuation in EUR/USD that is not counter acted in USD/CHF. This is
generally not a reliable way to hedge unless you are building a complicated hedge that takes
many currency pairs into account.
Forex Options
A forex option is an agreement to conduct an exchange at a specified price in the future. For
example, say you place a long trade on EUR/USD at 1.30. To protect that position you place
a forex strike option at 1.29. What this means is if the EUR/USD falls to 1.29 within the time
specified for your option, you get paid out on that option. How much you get paid depends on
market conditions when you buy the option and the size of the option. If the EUR/USD does
not reach that price in the specified time, you lose only the purchase price of the option.
The farther away from the market price your option at the time of purchase, the bigger the
payout will be if the price is hit within the specified time.
Reasons to Hedge
The main reason that you want to use hedging on your trades is to limit risk. Hedging can be
a bigger part of your trading plan if done carefully. It should only be used by experienced
traders that understand market swings and timing. Playing with hedging without adequate
trading experience could be a disaster for your account.