How Do Forward Contracts Work for Foreign Currencies?

Forward contracts are long-term agreements between a buyer and seller to exchange an asset at a predetermined price on a future date. Of course, these contracts have many uses in everyday finance, but they're also frequently used in the foreign exchange market, where currencies are bought and sold against each other.

For example, suppose Trader A needs to pay $10 million worth of Euros in three months' time, but only has US dollars at the moment. Trader A could enter into a forward contract with a brokerage at the current exchange rate of Euros to Dollars. Then, at the agreed-upon settlement date, both parties must settle their obligations to each other—Trader A pays its US dollar obligation to the brokerage and receives its Euros from them in return. Even though there is some risk involved, this type of transaction provides some degree of financial security for both parties involved.

In addition to locking in a price, forward contracts also allow currency traders to hedge against risk. By guaranteeing a predetermined rate at which they can buy or sell a currency, investors and traders alike can protect themselves from losses due to unexpected market volatility.

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Why Should You Use a Forward Contract?

While they are not suitable for every situation, they can offer profitable exit positions as well as financial security in the right circumstances. However, it is important to consider all risks involved before entering into a forward contract, as these may not always be beneficial. For example, if the currency pair moves against the trader, they may have to pay higher than expected.

Ultimately, traders should use their own judgment and do thorough research in order to make the best decision for their positions.

» Ready to enter the forex market? Read more about trading CFDs on currencies with Fortrade

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