What Are Outrights in the Forex Market?

Many international corporations routinely use forward outright contracts to hedge FX market exposures against adverse moves and help stabilize their foreign currency cash flow. Unlike currency futures contracts that trade on an exchange, forward outright contracts are traded in the foreign exchange market.

In essence, a forward outright contract in the forex market involves a party and a counterparty agreeing to buy or sell a predetermined amount of one currency against another at a fixed exchange rate for delivery on a specific date in the future.

Other names for forward outright contracts include a currency forward, an FX forward or an outright transaction.

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How Outrights Works

To understand the forward outright contracts used in forex trading, you first need to understand the forex spot market. In a nutshell, transactions in the forex spot market are settled “on the spot.” In practice, this means that spot transactions generally settle in two business days from the current trading day.

Unlike spot transactions, forward outright contracts generally settle on a day other than the current spot value date. As a result, the exchange rate of the forward outright contract also includes an interest rate calculation that depends on the difference between the prevailing interbank deposit interest rates of each currency in the transacted pair. When it comes to forex trades, forward contract is a popular derivative market traded in foreign exchange market by market participants to hedge risk against exchange rate fluctuations.

Unless prevailing interest rates are identical for both currencies, the interest rate differential generally benefits the party to a forward outright transaction that holds the higher interest rate currency. The party holding the lower interest rate currency must pay the interest rate difference over the duration of the forward outright contract.

In most cases, a forward outright trader must either pay the difference between the two interest rates for a currency pair or collect that differential, depending on whether the trader is positioned long or short in the forward outright. This differential is incorporated into the exchange rate of the forward outright contract by adding or subtracting the appropriate amount of swap points that are quoted by a forex forward desk in the foreign exchange market.

How Does an Outright Forward Contract Differ From a Swap?

An outright forward is a one-legged transaction executed for a forward value date that is different from the current spot value date. Contrast that with an FX swap that consists of a two-legged transaction that switches a forex position’s value date, usually to one further out in the future. The FX forward market is a segment of the foreign exchange market where a contract is traded to buy or sell a certain currency at a predetermined price and a specified future date.

With respect to risk, the main difference between an FX outrights position and an FX swap is that in the fx outrights forex trades, you’re exposed to both market and interest rate differential risk. In contrast, an FX swap only exposes you to changes in the interest rate differential.

In practice, currency traders might execute forward outright trades as part of their forex strategy by first doing a spot transaction. They then perform an FX swap to swap out the spot position to the intended delivery date. This process lets them cover the more volatile spot market risk quickly and then roll the position out at a more relaxed pace since the swap points tend to be more stable. 

How Do You Calculate a Forward Outright?

Calculating the forward outright rate of a currency pair for a particular desired future date can be done using this formula:

Forward Outright Exchange Rate or F= S[(1 + i_f)/ (1 + id)]

Where: 

S= the spot exchange rate for the currency pair

i_f = the foreign or counter currency interbank deposit rate for the desired future date
i_d= the domestic or base currency interbank deposit rate for the desired future date

If the delivery date is not an entire year in the future, and you are being quoted annualized interest rates, then it will be necessary to convert those rates to partial year interest rates to use the above equation. You can do so for the domestic or foreign interest rates using this calculation: 

partial year interest rate= annual interest rate x (# days to settlement/# days in a year)

Computing the swap points to a particular value date involves taking the difference in pips between the forward outright rate F calculated above and the current spot rate S. 

Swap points= F - S

Knowing the swap points to a certain value date means you can easily compute the forward outright rate for delivery on that same value date once you are given a spot exchange rate quote. Remember that if you are buying the currency pair outright as the client to a forex broker or market maker, then you will be trading at the offer side of the quoted spot rate and swap points. 

Advantages of Forward Outrights

Forward outrights offer several key advantages that make them a popular tool for managing currency risk and planning future transactions in the forex market:

1. Hedge Against Currency Risk: One of the primary benefits of forward outrights is the ability to lock in an exchange rate for a future date. This is particularly valuable for businesses and investors who want to protect themselves against unfavorable currency fluctuations.
2. Customizable Terms: Forward outright contracts are over-the-counter (OTC) instruments, allowing them to be tailored to the specific needs of the parties involved. Traders can set their preferred contract duration, currency pairs, and amounts, providing flexibility that is often not available with standardized futures contracts.
3. No Initial Cash Outlay: Unlike options contracts that require a premium, forward outright contracts generally do not require an upfront payment. This means investors can secure a future exchange rate without tying up capital, providing better liquidity for other investments.
4. Locked-In Exchange Rate: For businesses involved in international trade or investors exposed to foreign currencies, forward outrights provide certainty. By locking in a rate, they can plan future cash flows or costs more accurately, avoiding financial surprises due to fluctuating exchange rates.
5. No Margin Requirements: Forward outrights are not subject to margin calls like futures contracts. This can make them less risky in terms of sudden cash flow demands, as traders do not need to post additional collateral to maintain their positions.
6. Protection Against Unfavorable Movements: While you may miss out on favorable movements, the protection from unfavorable currency moves can be a crucial advantage. For businesses, this stability helps in budgeting and financial planning when dealing with multiple currencies.
7. Simpler Than Options or Swaps: Compared to more complex derivatives like options or swaps, forward outrights are relatively straightforward. They involve a simple exchange of currencies at a pre-agreed rate and date, making them easier to understand and execute for those focused on currency risk management.

Disadvantages of Forward Outrights

Forward outrights, while useful in hedging against currency risk, come with several disadvantages that traders and investors should consider:

1. Lack of Flexibility: Once a forward outright contract is agreed upon, it is locked in at a fixed rate and date. This can be limiting if market conditions change, as traders cannot adjust the terms without incurring penalties or fees.
2. Opportunity Cost: If the market moves in a favorable direction after the forward outright has been agreed upon, the trader loses the opportunity to benefit from these gains since they are bound by the terms of the contract.
3. Counterparty Risk: Forward outright contracts are often over-the-counter (OTC) instruments, meaning they are not traded on an exchange. This introduces the risk that the counterparty may default on the contract, potentially leading to financial losses.
4. Liquidity Concerns: In some cases, especially for less common currency pairs, forward outright contracts may have lower liquidity compared to spot forex trades, making it harder to enter or exit positions at optimal prices.
5. No Daily Mark-to-Market: Unlike futures contracts, forward outrights do not have a daily mark-to-market process, meaning the losses or gains are only realized at the end of the contract period, which can lead to larger-than-expected exposure.
6. Complex Pricing: The pricing of forward outrights can be more complicated than spot forex transactions, as it involves interest rate differentials between the two currencies over time. This can make it difficult for less-experienced traders to accurately assess whether the contract offers good value.

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