An FX forward is an agreement to exchange one currency for another at a fixed exchange rate on a defined future date. Unlike a spot transaction (which settles in two business days), an FX forward locks in the exchange rate today for settlement weeks, months, or even years in the future.
The covered interest parity principle
FX forward rates are not predictions of where the spot rate will be in the future — they are mathematically derived from the current spot rate and the interest rate differential between the two currencies. This is the covered interest parity relationship: if you can deposit money in currency A at one interest rate, or convert to currency B and deposit at a different rate, the forward rate must be set so that neither strategy is free money.
In practice, this means currencies with higher interest rates trade at a forward discount (the forward rate is weaker than spot), while currencies with lower interest rates trade at a forward premium.
Who uses FX forwards
Corporates use FX forwards to hedge known future currency exposures: an exporter who will receive foreign currency in three months locks in the rate today, eliminating uncertainty about their home-currency revenue. Importers use forwards to fix the cost of future foreign currency purchases.
Asset managers use FX forwards to hedge the currency exposure of their foreign bond and equity holdings. Rolling a portfolio of forwards — buying back expiring forwards and selling new ones — is a large, routine operation for global asset managers.
Banks use FX forwards both to serve client hedging needs and as instruments in their own proprietary interest rate and currency positioning.
The bank's revenue
When a bank provides an FX forward to a client, it earns through the bid-offer spread on the forward rate. The bank's own hedging cost, its funding cost, and its risk appetite for holding the resulting exposure all feed into where the spread is set.
The precise mechanics of forward pricing, how cross-currency basis affects the simple covered interest parity relationship, and how banks manage the risk of a large client forward book are explored in Market Mechanics — the complete plain-English guide to how a bank's markets business works.