Forward Contract

Forwards are customized: the two parties agree the underlying, amount, price and settlement date. The most common forwards in fund portfolios are FX forwards, used to hedge non-base-currency assets or hedged share classes, but forwards also exist on commodities, rates (forward rate agreements) and securities. A non-deliverable forward (NDF) settles only the net difference in a convertible currency, and is used for currencies with capital controls.

Because forwards are bilateral and generally not centrally cleared, they carry counterparty credit risk. They are usually documented under an ISDA, and collateral may be exchanged under a Credit Support Annex; many physically settled FX forwards are exempt from mandatory margin rules, so exposure can build up uncollateralized.

How funds account for forwards. No premium is paid at inception, so the contract starts with a fair value close to zero. It is then valued daily as the difference between the contracted rate and the current forward rate for the remaining term, discounted to today; for FX this uses spot rates plus forward points, typically a Level 2 measurement. Changes are unrealized gains or losses until settlement or early close-out, when they become realized.

Lifecycle events and pitfalls. At maturity a deliverable forward settles gross in both currencies; an NDF settles net. Hedging programs usually roll forwards monthly or quarterly, closing the old contract and opening a new one, and each roll creates realized P&L and cash that must be allocated to the correct share class. Common errors are using spot instead of forward rates for valuation, allocating hedge P&L to the wrong class, missing the settlement leg in cash forecasts, and not reconciling open forwards to counterparty confirmations.

Example

A USD fund with a EUR-hedged share class sells USD 10M forward against EUR at 1.0850 for three months. If the three-month forward rate moves to 1.0950, the contract has a mark-to-market value that is allocated only to the EUR share class.