A currency forward contract is a very useful tool for transferring money internationally. Exchange rates can be volatile and change with the ebbs and flows of the market. If you are buying or selling assets in a foreign currency, such as a real estate or piece of equipment, a sudden change in the rate can undermine the value of any underlying transaction to which it attaches.
This form currency risk can certainly invoke anxiety, and if the market moves the wrong way, potentially cost you a lot of money in the process. In this post, we’ll take a look at forward exchange contracts and explore how they can be used to hedge against future movements in the foreign exchange market.
What is a currency forward contract?
A currency forward contract is a foreign exchange tool that can be used to hedge against movements in between two currencies. It is an agreement between two parties to complete a foreign exchange transaction at a future date, with an exchange rate defined today. For example, an agreement to sell another party £50,000 for €50,875 in six months time, at the rate of GBP/EUR 1.1175.
Entering into a currency forward contract does not require an upfront payment of any sort, but it is a contractual arrangement between the two parties. This means that you must proceed with the agreed transaction, no matter what occurs after the agreement has been made. Even if the exchange rate has since moved in your favour, and that you’d be better off not proceeding with the forward exchange contract, you’ll still need to honour the original terms.
This is not all bad news, though. The primary reason for entering into a forward exchange contract is to limit the downside risk associated with the movements in the exchange rate. Exchange rates change every day, and sometimes they can change quite a lot. By choosing to lock down the rate today for payment at a future time, you remove the unknown risks associated with future movements in the market.
A simple forward exchange contract example
Let’s say that you are from the United Kingdom and you have just agreed to buy a house in Italy. The purchase price may have been agreed today, but the settlement of the property – the actual transfer of funds from the buyer to the seller – may not occur for another three months. If the exchange rate was to change over this time, you could end up paying much more for the property than you originally thought.
To hedge against this, you can purchase a currency forward contract. This contract would specify that you intend to exchange Pounds for Euros in three months time at an exchange rate specified today. The benefit of doing this is that if the Pound depreciates against the Euro throughout this time, you will have successfully hedged your risk – saving you money for your effort.
Now, of course, there is an opportunity cost when using a forward contract. The cost of using a currency forward contract is that you will forego any benefits of the currency appreciating in your favour. But keep in mind, that predicting the future value of currencies is not easy, and unless you have a crystal ball, I wouldn’t recommend trying. So a forward exchange contract will protect you against unfavourable movements, but you cannot benefit from favourable movements.
Here is a quick summary of the pros and cons of using a currency forward contract:
- Forward contracts protect you from unfavorable exchange rate movements
- If the exchange rate moves against you, you save money and are better off overall
- You don’t actually have to pay for your transfer until the forward contract matures
- By locking in an exchange rate, you have piece of mind in the underlying value of any transaction
- The exchange rate could improve in your favor and you will miss out on any benefits of this
Where can you buy a forward exchange contract?
Banks and other large financial institutions are the traditional providers of foreign exchange services, including forward exchange contracts. However, these banks, despite their size and the strength of relationships with their clients, are often expensive. This means that they may not always provide rates that get close to the mid-market rate.
A better alternative to using a bank is to consider an international payment specialist. These companies are essentially dedicated foreign exchange brokers who can assist with providing advice in regards to not only spot payments and future contracts, but also an assortment of options, market orders, and multi-currency accounts.
Here is a list of services that can assist you with a currency forward contract:
|wdt_ID||Service||Countries||Speed||Ave. cost||Our score||Review|
|2||XE Money Transfer||220||2-4 days||0.54 %||4 stars||Read review|
|11||TorFX||176||2-4 days||2.12 %||3 stars||Read review|
|12||Currencies Direct||188||2-4 days||1.79 %||3 stars||Read review|
|20||RationalFX||201||2-4 days||1.16 %||3 stars||Read review|
|21||OFX||226||3-5 days||1.72 %||4 stars||Read review|
How is a forward contract priced?
The price of a currency forward contract is calculated using a couple of factors, including the current spot price of a particular currency pairing, as well as the effective interest rate in each country. The calculation itself is quite complicated, so we won’t go into it in any details here, however, the important take away is that a forward exchange contract rate will generally be slightly lower than the current available spot rate in any currency pairing.
For example, let’s just say that the current GBP/AUD spot price is 1.8306; meaning that 1 British Pound is worth 1.8306 Australian Dollars. In this instance, it would not be unusual for the GBP/AUD forward rate to be quoted as 1.8206. The effect of this is that if you wanted to enter into a forward exchange contract with a maturity date in, say, three months time, the rate available to you would be slightly less overall – 1.8206, rather than the current spot rate of 1.8306.
Using currency forward contracts in business
Future contracts can be especially useful for businesses conducting activities internationally. If assets or stock needs to be acquired in a foreign denominated currency, a currency forward contract will enable you to adequately budget for this transaction ahead of time.
Let’s consider a clothing manufacturer in Australia who sources wool for their outdoor products in New Zealand. They are provided with an invoice for NZ$ 100,000 from their wool supplier that is due to be settled in 60 days time. The AUD/NZD exchange rate is currently 1.0911, which means that the cost of acquiring NZ$ 100,000 today is AU$ 91,649. Let’s assume that we decide to be safe and buy a forward contract at AUD/NZD 1.0811 that matures in 60 days.
The total cost of acquiring NZ$ 100,000 is now AU$ 92,498; slightly more than the current spot rate, but we don’t need to transfer the funds for 60 days. This is the maturity date of the forward and also the due date of the supplier’s invoice. Between now and the due date, the exchange rate will almost certainly fluctuate, but the important thing for us is that we have locked down an exchange rate, so we know exactly how much we’re going to pay.
Let’s quickly examine the effects of this forward contract on the possible scenarios. Consider that in 60 days the Australian Dollar had depreciated against the New Zealand Dollar to 1.0511. If we had not decided to purchase a forward contract and instead made a spot contract at the time payment was due, the cost of funding the NZ$ 100,000 transaction would be AU$ 95,138. Therefore, by using a forward contract we have saved ourselves AU$ 2,640; a good result overall!
Of course, if the Australian Dollar moved the other way and appreciated against the New Zealand Dollar, we would have been better off to wait. But unless you had some magic ability to predict this, you would never know this ahead of time. Either way, in this example, the currency forward contract has completed its purpose; it has protected our wool manufacturer’s margins, so he can price the cost of the input into his process with confidence.
Combining forwards with options
Now, we have described that by using a forward contract, you give up any benefits resulting from a favourable movement in your currency. If you have more technical requirements, however, this is not always the case. Some sophisticated clients, with a little bit of professional help, may combine a forward contract with an option; allowing them to benefit whichever direction a currency moves.
An option is an advanced tool that provides you with the right, but not the obligation, to purchase a specified amount of foreign exchange in the future. It often requires the payment of a small premium to acquire the option and can be used in conjunction with forwards or on their own. If you’d like to read more about using options, take a look at our post on the subject.
Currency forward contracts are a useful tool for managing foreign exchange risk. By agreeing to purchase currency for a future date at today’s prices, you can effectively hedge against undesirable movements in the exchange rate. This can save you money and the potential of a headache when conducting large transfers for real estate or other property. While banks are often able to assist you with this function, international payment specialist can often secure more competitive exchange rates.