Let's take a look at the market risk embedded in FX forwards using a specific example.

Imagine we've agreed to buy 100 million Euros against US Dollars on a six month forward basis at a rate of 1.10391. And let's assume you hold no other positions using the interest rate parity formula. The FX forward rate is calculated based on three variables, the FX spot rates, as well as the interest rates of the two currencies. So in this example, what is the exposure to the FX spot rates? Since we've agreed to buy Euros and sell Dollars on a forward basis, we've locked in the rates at which we'll exchange currencies in six months.

If the US Dollar strengthens in the meantime, we'd face a mark-to-market loss. Why? Because a stronger Dollar would allow us to buy the same 100 million Euros in exchange for fewer Dollars at the new spot rate, making our forward agreements less favorable. In general, once we've agreed to buy an asset, whether on a spot or forward basis, we don't want to see its price decline.

In this particular case, we don't want the Euro to weaken, or in other words, the US Dollar to strengthen.

Now let's move on to interest rates exposures. Are we long or short Euro and US Dollar interest rates? In other words, will we benefit from a rise in US Dollars or Euro interest rates? And how about a decline? This is a bits less intuitive than the spot exposure, but we can break it down. And FX forward is equivalent to three underlying transactions buying Euros in the spot market today, investing them and simultaneously borrowing the required US Dollars to settle the spot transaction.

By entering into the forward trade, we've effectively fixed the Euro investment rates and the Euro Dollar borrowing rate for the six month forward period. This means we don't want Euro interest rates to increase as that would make our locked in investment rate less attractive. Similarly, we don't want US Dollar interest rates to fall as that would make our locked in borrowing rates relatively more expensive.

To summarize, our long Position in a six month Euro US Dollar forward gives us two exposures. On the currency side, we have a long Euro versus US Dollar spot exposure. And in relation to interest rates, we have a long position in Euro interest rates and a short position in US Dollar interest rates.