Please see “Spot Exchange Rate” article by Alexander Calvo for reference to an explanation of the Spot Exchange Rate. As we learned on that article, the spot rate is the “current” rate both firms agree to exchange currencies usually within 24 or 48 hours. On the other hand, Forward Exchange Rate is a rate quoted today for an exchange between two firms that will occur in the future. Usually the delivery or payment on the exchange is done within 30, 90 or 180 days.

The forward rate will be determined by the estimated supply and demand for currencies since there is no government intervention in this free money market. The forward rate would be an estimate of the future spot rate but it is ultimate uncertain. If the forward rate and the future spot rate are the same then it means that there is no much variation in the currency. However, the forward rate contract helps firms hedge uncertainty in foreign exchange risk when the foreign currency is volatile.

For example, the Canadian Forward Rate according to the Wall Street Journal traded yesterday at $.9517/CAD, the forward rate for one month or 30 days is $.9517/CAD, the forward rate for three months or 90 days is $.9516/CAD, and the forward rate for six months or 180 days is $.9516/CAD. In this situation, the exchange rate is pretty stable with no much variation. Small companies trading in small quantities may not need a forward contract because the fee paid to the bank for the forward contract will put the firm in a disadvantage when trading the currency. On the other hand, big firms may require the forward contract because there is a chance that the future rate would stay the same as today’s rate $.9517/CAD which is $.0001/CAD more than forward 90 day quote $.9516/CAD. In this case, if the company has a contract to exchange $10,000,000.00 into Canadian Dollars then the company just saved

$10,000. Again, the company might be better off depending on the fee charged by the bank.

Nevertheless, in other countries the exchange rate fluctuates often and at higher intervals. So it is convenient to have a forward contract if you plan on purchasing foreign currency which rate is volatile and/or there is political risk. Any political decision in the foreign country may affect the future spot rate which may favor or disfavor to your forward exchange rate contract.

Sources:

http://online.wsj.com/mdc/public/page/2_3021-forex.html?mod=topnav_2_3014

http://www.ifc.org/ifcext/essaycompetition.nsf/AttachmentsByTitle/Silver_essay_Hedging_Forex_Risk/$FILE/Silver_Hedging+Forex+Risk.pdf

http://www-wds.worldbank.org/external/default/main?pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64886411&theSitePK=6313037&entityID=000020439_20070122154347&searchMenuPK=64886411&theSitePK=6313037