Forward Contract – Secure an Exchange Rate
Forward contracts, are a simple risk management solution that allows you to secure an exchange rate today, but for settlement at a specific date in the future. The exchange rate is secure on the day that you come to an agreement, fixing the buy and sell amount, as well as the date in which the contract will mature. If you want to protect your foreign currency exposure from volatility then forward contracts are an effective hedging tool when it comes to future payments.
Benefits of a Forward Contract
- With the exchange rate and a specific price secured, the cost of your international payment won’t change, regardless of any movements in the foreign exchange market
- Businesses who want to budget effectively and manage their cashflow. Forward contracts remove the volatility and unpredictability of the currency markets
- Individuals who want to fix the buy or sell amount for a future investment, enjoy the peace of mind that the cost will never fluctuate
Case Study using a Forward Contract
A company buying goods from a supplier in 6 months time.
XYZ Ltd forecasts that they will be buying goods from their supplier in 6 months’ time. The value of the purchased goods is $100,000 USD. The forward contract exchange rate for GBP/USD of 1.30 meant the cost to the company was £76,923 GBP. The company decided to secure this specific price, budget for the fixed cost of the goods, and settle the contract (i.e. transfer the money) on the agreed settlement date in 6 months’ time. The alternative would have been to sell GBP and buy the USD at the spot rate in the future, if the spot rate at that time moved to a rate of 1.28 (GBP/USD) the goods would cost the company £78,125, which is an extra cost of £1,202 GBP. This shows how crucial it can be to take advantage of a forward contract, especially from a budgeting perspective.
Despite this example showing the negative impact of currency movements, it is also worth considering how the market could alter in the company’s favour and so, the $100,000 USD could cost less. Yet, to budget effectively and manage cash flow, the company did not want to take the risk and preferred the option of securing the rate, and the buy and sell amounts, affording peace of mind that the cost would not change.
Forward Contract Types
There are different types of forward contracts available. The following contract types can be ideal for certain situations, but you should ensure you speak with a specialist, such as NewbridgeFX, who can explain what the best option is for your particular situation.
- Fixed forwards contracts – make it possible to exchange one currency for another on a fixed date in the future. You secure the exchange rate today, and settle the contract (i.e. transfer your money), on the specified date in the future
- Open, Flexible, or Variable forward contracts – make it possible to exchange currencies, and secure an exchange rate today for settlement on a specified date in the future. Yet with these options, you would also be able to draw-down and use some, or all, of the contract before the original settlement date. This is useful if you may need to send funds, or have access to the funds, before the agreed future date.
- NDF’s (non-deliverable forwards), Time Options, and Window Forward Contracts – there are other types of forward contracts such as NDF’s (non-deliverable forwards), Time Options, and Window contracts, which are less common, but may be suitable for you. Speak to NewbridgeFX for further information
- Secure an exchange rate today, for settlement at a future date, avoiding any risk of the exchange rates moving against you
- Effective budgeting for businesses and individuals as the cost is secure and will not change, thus improving cash flow management
- Securing a specific price protects from market volatility and economic uncertainty
- Flexible forward contracts enable you to use the contract before the pre-agreed settlement date
How do I secure a forward contract with NewbridgeFX
Once you register an account, you can ask for a forward contract to buy a specific amount of currency, at a specified date in the future. If you confirm you want to proceed the contract becomes an agreement between both parties, and the exchange rate is secure and locked in. You would need to transfer a deposit, held as a balance against the contract (5% of the value of the contract is common). When the settlement date (otherwise known as the maturity date) arrives, you transfer the remaining balance to our account. Once received we will transfer the agreed amount of currency to your nominated beneficiary account. The contract agreement is then finalised
What is the cost of a forward contract
There are no costs, or transfer fees to secure a forward contract agreement. The buy and sell amounts would be secure and fixed for the duration of the contract
Why are forward contracts useful
Whether you are a business or individual, forward contracts enable you to secure an exchange rate today, for settlement at a future date. You also fix the buy and sell amounts so the cost doesn’t change regardless of exchange rate movements on the currency market. A forward contract agreement is also helpful from a cashflow perspective
What are the disadvantages of a forward contract
As a forward contract secures the exchange rate and fixes the buy and sell amounts, it does mean you cannot take advantage of the exchange rates if they continue to rise and become even more beneficial for you. A forward contract protects you if the rate declines, but you cannot benefit if the rate continues to improve and moves more in your favour. Forward contracts are an effective risk management strategy
Using forward contracts as part of a hedging strategy
While forward contracts can protect against the exchange rates declining over time, you cannot take advantage if the exchange rates continue to rise. As a result, there are various hedging strategies to utilise, such as securing 50% of the total value as a forward contract, with the remaining value booked as a spot contract at a later date. You could also use Market Orders to secure the remaining 50% value should your desired exchange rate be obtainable in the future; but Market Orders will only execute should your desired rate be achievable in the market, and are not guaranteed. NewbridgeFX can help you set an appropriate risk management hedging strategy to help you achieve your objectives
How are forward exchange rates calculated
In simple terms, interest rate differentials between two currencies determine a forward contract exchange rate. They are not a forecast of where the exchange rates may be in the future. If you are selling a currency where the country has a lower interest rate, compared to the buy currency/country, then the forward rate will be higher than the current spot rate, and vice-versa
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