The concept of forward trading exists in many markets and traders contract to the delivery of specified items on a preset future date. In the trade of real currency the Forward exchange market allows the delivery of foreign currency in the future at a specific exchange rate. This exchange rate is known as the forward rate of a forward contract and is different to the spot rate that prevails in the market and is dependant on the time of delivery which can be anywhere from days and months to even years.
As a rule, the forward rate is determined by the supply and demand for the currency and is a good indication of spot rates in the future. Forward contracts are used by traders to insure against foreign exchange risk. The need for forward contracts generally arises from trade, capital movements, arbitrage activities and speculative transactions.
Spot rates and forward rates are closely related to one another and thus act upon each other. Investors in the forward exchange market take a close look at the spot rates before they quote forward exchange rates. Both these types of exchange rates move in the same identical direction as can be expected. At certain times when the spot rate shifts considerably from its stable position then the corresponding forward rate tends to reverse its course before the spot rate does.
The exchange rate in different countries can vary and this gives rise to moving the currency to the country with the better exchange rate. The traders who do this however are careful to take cover from the possible risks that may arise by buying of forward currency. There can be many factors that influence the balance between the spot rate and the forward rate. For instance, the above situation where currencies are transferred from one place to another the interest difference tends to reduce. Then the inducement for transferring of the funds and the potential for profiting from the trade disappear.
Investors in the currency market tend to use open positions or uncovered positions to capitalize on the changes in exchange rates. For example if the investor is expecting the dollar to depreciate he will proceed to sell forward dollars at a slightly higher rate than can be expected. Similarly, the expectation of a stronger dollar in the future will spur the investor to buy dollars for a rate which is lower than the expected rate. If the market predictions come true the investor stands to profit from it without doubt.