A currency forward contract is a very useful tool for foreign exchange risk management. If you are buying or selling assets in another currency, a sudden change in the exchange rate can undermine the value of the underlying transaction.
Exchange rates can be volatile and change with the ebbs and flows of the market. This type of currency exposure can easily 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 explore how a currency forward contract works and list the services offering this payment feature.
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What is a currency forward contract?
A currency forward contract is a foreign exchange tool that can be used to hedge against movements 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, but it is a contractual arrangement between 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 would be better off not proceeding with the forward exchange contract, you’ll still need to honour the original terms.
It’s 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.
What services offer a forward a contract?
Here is a list of services that offer a currency forward contract. Beside the name of each service, we have included its average cost, speed of transfer, receiving countries, and our review score – sorted from highest to lowest.
To sort this chart by column, click its respective headings. If you are reading on mobile, you may need to scroll horizontally to view all fields.
|wdt_ID||Service||Ave. cost||Speed||Countries||Our score||Review|
|2||XE Money Transfer||0.54%||2-4 days||220||4 stars||Read review|
|11||TorFX||2.12%||2-4 days||176||3 stars||Read review|
|12||Currencies Direct||1.79%||2-4 days||188||3 stars||Read review|
|20||RationalFX||1.16%||2-4 days||201||3 stars||Read review|
|21||OFX||1.72%||3-5 days||226||4 stars||Read review|
|22||WorldFirst||1.11%||2-4 days||243||4 stars||Read review|
Forward contract example: Buying a house in Italy
Let’s say that you are from the UK 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 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 between now and then, you will have successfully hedged your risk – saving you money.
Of course, there is an opportunity cost when using a forward contract, in 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, we wouldn’t recommend it. So a forward exchange contract will protect you against unfavourable movements, but you cannot benefit from favourable movements.
The benefits of a forward contract
Here is a quick summary of the pros and cons of using a currency forward contract:
- Forwards 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
How is a forward priced?
The price of a currency forward contract is calculated using few factors, such as the current spot price of a particular currency pairing, and the interest rates in each country. The calculation itself is quite complicated, so we won’t go into the details here. However, the key takeaway is that a forward rate will generally be slightly more expensive than the mid-market rate.
For example, let’s say that the current rate for a GBP/AUD spot contract 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 – approximately 0.50% more expensive than the current spot rate.
Using forwards in business
A forward contract can be especially useful for a business 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.
Example: Clothing manufacturing
For example, 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$92,498; slightly more than the current spot rate, but we don’t need to transfer the funds for 60 days. This is the maturity date of the forward and also the due date of the supplier’s invoice. Between now and the due date, the exchange rate will almost certainly fluctuate, but the important thing for us is that we have locked down an exchange rate, so we know exactly how much we’re going to pay.
Evaluating the possibilities
Let’s quickly examine the effects of this forward contract on the possible scenarios. Imagine that in 60 days the Australian Dollar had depreciated against the New Zealand Dollar to 1.0511. If we had not decided to purchase a forward contract and instead made a spot contract at the time payment was due, the cost of funding the NZ$ 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
So far, we have described that by using a forward contract, you give up any benefits resulting from a favourable movement in your currency. However, if you conduct a more sophisticated style of transaction, this may not be the case. With a little bit of professional help, it is possible to combine a forward with an option; allowing you to benefit whichever direction a currency moves.
Foreign currency options are another 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 a forward, or on its own.
A forward contract is 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. This can save you money and the potential of a headache when conducting large international transactions. While banks can assist you with this function, a specialised transfer service can often secure more competitive rates.
If you have any questions or feedback, let us know in the comments below.