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Spot & Forward Foreign Exchange

Spot & Forward Foreign Exchange


Foreign exchange is defined as “a claim to a foreign currency payable abroad and may be funds held, bills or cheques”. 

A foreign exchange transaction is, “a contract agreed today between two parties to trade an agreed amount of one currency for an agreed amount of another currency on a future date”.

When you travel you may be familiar with buying currency at the airport. Because the sums involved are small and paper money is exchanged the differences between buying and selling prices can be wide. You may also be unfortunate enough to pay a dealing fee.


Banks, corporates and speculators deal in the professional market. Trades are transacted across electronic platforms and each trade can run into millions of dollars. As a consequence dealing spreads are very narrow and the money is exchanged by credits and debits to bank accounts. Let's find out about the spot and forward markets and the risks involved.

The spot market 

The spot market is where one currency is purchased and another currency is sold and settlement occurs within two days. When two dealers trade what do they need to agree?

  • The currency that is being purchased;

  • The currency that is being sold;

  • The amounts involved;

  • The foreign exchange rate (FX rate);

  • The settlement date;

These basic trade details are agreed in a matter of seconds. They have to be because the FX rate is continually changing. That’s why a dealer cannot leave a quote open for long.

Where does the rate come from? It’s the price quoted by one of the dealers (classically the “market maker”). If you are the customer you can compare it with Reuters or Bloomberg and it shouldn’t be much different. If it is ask for another quote. 

To the novice dealing prices can be confusing. That’s because there is a buying and selling price and what you get depends on what you want to do. Let’s find out more.


The US Dollar (USD) is frequently used as the base currency. Most transactions involving the USD are quoted in units of currency per one USD, (the main exception being Sterling). 

Let’s look at a quote.

This is for USD versus CHF (Swiss Francs)

USD/CHF        1.1410 – 1.1420

The first currency in the pair is the dollar USD/CHF. This means the quote is for the number of CHF per dollar.

There are two prices. 

The dealer buys USD at CHF 1.1410

The dealer sells USD at CHF 1.1420 

If you sold USD 1,000,000 to the dealer you would receive CHF 1,141,000 (1.1410)

If you bought USD 1,000,000 from the dealer you would pay CHF 1,142,000 (1.1420) 

To earn a profit the dealer buys US dollars at the lowest possible currency rate and sells US dollars at the highest possible currency rate (buy low, sell high).

The dealer is looking for flow. The more customers he quotes the more opportunity he has of gaining the spread. It’s why if you bought and sold you would just lose CHF1,000!

Changing the base currency  

Not all currencies are quoted on the same basis. Sterling (GBP) is often quoted as the number of dollars per pound, (Sterling is the base currency). 

GBP/USD 1.5802-1.5812 

The dealer buys GBP 1,000,000 for USD 1,580,200 (1.5802)

The dealer sells GBP 1,000,000 for USD 1,581,200 (1.5812) 

In this case the left hand quote is a “bid price” for pounds and the right hand quote is an “offer price” for pounds.


Sometimes the base currency is reversed. Let’s see the GBP/USD quote when the base currency is USD.

USD/GBP 0.6324 - 0.6328

The dealer buys USD 1,000,000 for GBP 632,400 (0.6324)

The dealer sells USD 1,000,000 for GBP 632,800 (0.6328)


For spot deals the trade details are agreed today but the exchange of currencies normally occurs two working days later. There are exceptions, for example Canadian dollars trade with one day settlement. 

To settle a trade correctly the trade details must be confirmed by operations. In the foreign exchange market confirmations are often automated with unmatched trades forming an exception report.

Both parties need accounts denominated in the currencies being bought and sold. These accounts are sometimes referred to as nostro accounts.


Foreign exchange trades affect cash positions. So payments need to be funded in order to avoid going overdrawn and receipts need to be added to dealer’s cash positions so they can be placed in the market to earn interest.

Settlement Risk

Settlement risk is also called Herstatt risk after the default of a German bank in 1974 sent tremours around world markets.

It is the credit risk incurred when paying a currency away before receiving the counter currency. Typically this risk only lasts for a few minutes or hours but should the counterparty default the sums involved are enormous. Firms need to ensure the appropriate risk limits are in place before dealing can take place. Banks have developed ways to reduce this risk including netting and continuously linked settlement

The forward market

A forward foreign exchange transaction (FX forward) is a deal where the rate is agreed today for the sale of one currency and purchase of another on a specified date beyond the spot date.


Forward transactions are often associated with hedging anticipated inflows or outflows of currency. For example an exporter in Europe anticipates receiving dollars. The exporter has a choice. Sell the dollars at the prevailing spot rate when they arrive or sell the dollars forward at a rate agreed now. 

Let’s suppose the sum involved was USD 1,000,000 due in 3 months.

Currently the spot rate is EUR/USD 1.4700

But the exporter must wait until the dollars are received before being able to deal in the spot market. 

In three months time what the exporter gets depends on the prevailing spot rate: 

USD1,000,000 at 1.5700 = EUR 636,943

USD1,000,000 at 1.4700 = EUR 680,272

USD1,000,000 at 1.3700 = EUR 729,927 

It just depends where the spot rate is and it could be anywhere. The exporter is running foreign exchange risk and it could be too great for comfort. 

By entering a forward deal the exporter will be able to agree the rate now. So if the forward rate was 1.4800 the exporter locks in EUR 675,675 removing the uncertainty. 

A forward is a commitment 

When you enter a forward contract you agree the following: 

  • The currency that is being purchased;

  • The currency that is being sold;

  • The amounts involved;

  • The foreign exchange rate (FX rate);

  • The forward settlement date; 

A forward contract is a commitment you have the certainty of knowing exactly how much you will buy and sell and the date on which the deal will settle but the trade must be honoured. 

The currencies must be exchanged at the pre-agreed forward rate even if it is worse than the spot rate. If you cannot deliver then the contract must be closed out. Close-out will lead to a cost or benefit. This is calculated using the difference between the contracted forward rate and the prevailing spot rate. Forward contracts are therefore best suited to manage currency cash flows that are certain. 

Forward rates 

The forward rate quoted by a dealer is not a guess. It is determined by the spot rate and the two currency interest rates. Here is a simple example for a 3 month forward rate: 

USD/GBP Spot:  1.5000

USD Libor:           3.00%

GBP Libor:           1.00%

Days:                     91

A £1,000,000 3 month deposit would earn £2,493.15 interest giving £1,002,493.14

A $1,500,000 3 month deposit would earn $11,375.00 interest giving $1,511,375.00

The forward rate will therefore be 1,511,375.00/1,002,493.14 = 1.5076

(The market quote may differ slightly from this theoretic rate but should be close as a result of arbitrage boundaries). 

In this case the forward rate of 1.5076 is higher than the spot rate. This means there are more dollars per pound in the forward quote than the spot quote. It’s exactly what you would expect because in this example the USD interest rate is higher than the GBP interest rate. 

If we altered the interest rates to: 

USD Libor:                  1.00%

GBP Libor:                  3.00%

The forward rate now becomes 1.4926

Now there are fewer dollars per pound in the forward quote because the USD interest rate is lower than the GBP interest rate. 

The forward rate is sometimes referred to as the outright forward rate to differentiate it from the forward points

Forward points 

If you want to deal in the forward market you may get the dealer to quote an outright forward price but often the forward transaction is agreed in two steps.

The first is to agree the forward points the second is to agree the spot rate. What are the forward points? 

The forward points are the difference between the forward rate and the spot rate (the interest rate differential is being quoted in foreign exchange terms). In the earlier example the spot rate was 1.5000 and the forward rate 1.5076.


The forward points are 1.5076-1.5000 = 0.0076

But market convention is to quote this as a whole number so 0.0076 becomes 76 pips or points. 

If you subsequently agree the forward points (in this case +76) you now need to agree  the spot rate. Assuming this was 1.5000 the outright forward rate becomes 1.5000 + 0.0076 = 1.5076

Why do it like this? Because the spot rate is constantly changing whilst the forward points are relatively static, breaking the deal into two parts allows you to agree the interest rate differentials and the spot rate separately, making the price more transparent.

Credit risk 

Forward deals may create counterparty credit exposure. This is because you are reliant on your counterparty fulfilling their side of the contract on the settlement date. If they don’t you will have to deal at the prevailing spot rate (rather than the forward rate you agreed).


Any positive mark-to-market valuation you have constitutes a credit risk on your counterparty. Just how big could this exposure be? That depends on how much the forward rate changes, the size of the deal and its maturity. That’s why banks insist on having credit lines with counterparties beforethey deal. It’s also why credit utilization for forward deals is greater than for spot deals. There is simply more time for the valuation to alter. To mitigate this risk banks often use collateral management. Just like spot deals, forward trades also incur settlement risk on the day they settle. 

What changes spot rates? 

If you ask a dealer the response will be “supply and demand” so what alters these conditions? Many things here are a few.

  • Economic cycles

  • Monetary & fiscal policy

  • Speculation

  • Inflation

  • Taxation

  • Technical factors & expectation 

Here is a simple example of how these factors can work. A country facing an economic downturn may experience lower interest rates. Lower interest rates mean that foreign investors get a lower return holding the currency. This encourages selling. Some investors may speculate, shorting the currency and pushing its value down further. 

If the government decides to counter recession with spending this can increase borrowing requirements. If the county’s credit risk deteriorates it may weaken the currency further as investors reduce their exposure to the currency. But a weakened currency may encourage exports and government spending may return the economy to growth leading to rising interest rates.

The currency’s outlook may improve. If the central bank doesn’t increase interest rates and the expansion continues inflation may increase. Inflation tends to weaken a currency as investors seek to avoid its effects. Of course this is all subjective, does it sound familiar?

First Published by Barbican Consulting Limited 2009

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