Forward contracts are foreign exchange products used by foreign exchange brokers for businesses and individuals looking to make a money transfer at a future date from one currency to another but at the current foreign exchange rate.
How They Work
Forward contracts are used for a payment up to 24 months in the future but without paying upfront. Forward contracts allow individuals and businesses to protect themselves from currency fluctuations by securing the current foreign exchange rate as part of the forward contract. Full payment is made at a later date for the total amount when the transfer is completed.
A deposit is paid on agreeing to the forward contract, which is commonly 10% of the money transfer value. The remaining 90% is made payable before an agreed date in the future.
Uses
Forward contracts can be useful to those looking to capitalise on positive foreign exchange movements. They might either not yet have the money to purchase a spot contract in full or don’t need to trade immediately.
Types of Forward Contract
There are a few types of forward contract foreign exchange used by businesses and individuals to manage currency risk and lock in competitive currency exchange levels. They include the following.
Forward contract
A regular or standard forward contract allows a business or individual to lock in today’s spot rate of a currency pair for a deliverable date in the future. Essentially buy now (today’s spot rate) pay later. Upon deciding to fix a forward contract with a bank or foreign exchange broker, an exchange rate is agreed, the completion date set, and a deposit is taken (this is typically 5-10%).
A forward contract can be locked in for up to 2 years and allows a client or business to mitigate the risk of currency markets moving against them and making a purchase more expensive.
Flexible Forward Contract
A flexible forward contract has the same key points as the standard forward contract above. Still, it offers the added flexibility of being traded before the agreed date. Therefore, if your currency exchange is required sooner, you have the flexibility of completing the transfer beforehand. The forward contract can also be used to drawdown funds. A portion of the flexible forward contract can be executed. The same rate is held for the remainder of the funds allocated to the forward contract.
Window Forward Contract
A window foreign exchange contract allows you individuals and businesses to purchase foreign currency within a specific time frame. Similar in principle to a market order but allows the client to fix the rate for an execution date in the future.
Long term Forward Contract
The context of a long term or long-dated forward contract is typically for a forward contract that’s execution, or transfer date is more than three months in the future. Forward points attributed to these contracts will be more significant.
A non-deliverable Forward Contract
Most forward contracts taken up by individuals or businesses involve a currency exchange and transfer of funds. However, with a non-deliverable forward contract, there is no physical exchange or transfer of funds. With a non-deliverable forward, the counterparties settle the difference between the contract(s) exchange rate and the spot rate. The non-deliverable forward is typically implemented by businesses to hedge a currency risk when the local currency is not available. A non-deliverable forward contract will typically be for an exotic currency not widely traded on the foreign exchange market.
Options contract
An options contract offers the benefits of a standard forward contract with the advantage or ‘option’ to secure a superior rate because your currency pair’s exchange rate has improved. Typically, there will be a supplementary cost represented in the commission made by your FX provider. Options contracts are usually used by businesses exchanging vast sums of currency or making multiple payments.
Futures FX contract
The American rather than European markets use the term FX futures contract. They broadly mean the same thing and depict an FX forward contract’s fixing at the current spot rate for a deliverable date in the future.
Benefits
The benefits of a forward contract are protecting the value of your money transfer against unfavourable currency fluctuation. These currency fluctuations could come about due to significant events such as a recession, pandemic, war or an election.
If the value of the currency a person is transferring from decreases, or the currency moving to increases in the future, the money transferred value would be less than the current exchange rate. For large payments, this could be a significant amount of money lost.
For a business, this could have a detrimental impact on their profits if their purchasing power from international suppliers is reduced.
Agreeing to a forward contract helps fix an international money transfer cost, allowing an individual or business to plan, ensuring their foreign currency exchange value.
Disadvantages
Just as a currency can go up in value, it can also go down. Suppose a forward contract is set today for payment in the future. However, the value of the base currency increases or the value of the currency transferring to decreases. The client would lose out on the opportunity to increase the currency exchange value.
Example – Overseas Property
A client is selling a second property in France, which completes in 20 days. The property contract retraction time has lapsed, and the property transaction is unlikely to be delayed.
Between now and the completion the Euro hits a six-month high against GBP, and the client wants to benefit from this six-month high. The client opts to fix the rate with a deposit. Therefore, eliminating the possibility of GBP strengthening and guaranteeing the number of euros he converts, the number of pounds he receives and the rate he trades at.
Case Study – Business using Forward Contracts
A company buying goods from a supplier in 6 months
XYZ Ltd forecasts that they will be buying goods from their supplier in 6 months. The value of the goods to be purchased is $100,000. At the time, the forward contract exchange rate for GBP/USD of 1.30 means the cost to the company was £76,923.
The company decided to secure this rate, 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.
The alternative would be to purchase the USD at the spot rate in 6 months. If the spot rate at that time moves to a rate of 1.28 (GBP/USD), the goods would cost the company £78,125, which is an extra cost of £1,202. Proving how crucial it can be to take advantage of a forward contract, especially from a budget perspective.
Despite this example showing the negative impact of currency movements, it is also worth considering how the market could alter its favour so that the $100,000 could cost less.
However, to budget effectively and manage cash flow. The company did not want to take the risk and preferred securing the rate and having peace of mind that the cost would not change.
Booking
Foreign Exchange Broker
- NewbridgeFX – NewbridgeFX are a UK based foreign exchange broker that offer forward contracts to businesses and high net worth individuals to manage their foreign exchange risk.
Deposit
Foreign exchange brokers will typically require a deposit of between 5-10% for the majority of forward contracts the client books.
The percentage required will depend on trading history, the forward contract’s length, and the currency pairs involved. Typically, the longer the forward contract, the more deposit is required.
Larger corporations and businesses with a healthier balance sheet may have access to credit, meaning the deposit will be reduced or waived.
The deposit is transferred with the remainder of the currency when the forward contract matures. Deposits are held to guarantee the transfer as the foreign money is purchased upfront by the foreign exchange broker.
Zero Deposit Forwards – Businesses
Businesses with healthy balance sheets or long-term trading records might have the ability to lock in forward contracts without a deposit.
The foreign exchange broker is at liberty to offer or refuse this privilege. Many foreign exchange brokers won’t provide credit on forward contracts.
Forward contract pricing
Forward contract pricing will be subject to a few elements within the forward contract(s). These primary factors will affect the forward contract pricing include.
Forward points – interest rate differential
The forward points relate to the difference between interest rates of any two currencies. For example, if a client plans to use a forward contract for EUR/USD and the Euro interest rate is 1%. The USD rate is 2%, 1% more interest could be made by holding the US Dollar over the Euro. So, when a bank or foreign exchange broker factors in the difference in forward points, the difference is added to the rate to compensate for this interest loss. The longer the forward contract term, the more points are added to pay for the loss.
Appetite for certain currencies
The second element, considered by a foreign exchange bank or broker is the currency pairs involved. In particular, if the client wishes to purchase or sell an exotic currency. Due to less appetite and demand for exotic currencies than the primary (fiat) currencies, the margin added to the forward contract will be more significant.
Volume of currency
As with any commodity forward contract pricing becomes more competitive and advantageous as the volume of currency traded increases. Particularly prominent for large global corporations who purchase and sell multiple billions of foreign currencies every year. Many of which will are offered near interbank pricing on their forward contract or option deals.
Forward Contract Margin Calls
A margin call is a request for funds, to be held as a deposit against your forward contracts. It is instigated if the exposure of a forward agreement surpasses the predetermined variant margin.
The down payment enables you to maintain your forward contract position at the agreed forward contract currency rate. Foreign exchange brokers offer versatility around FX margin calls. Still, typically they are called for to be paid within two working days.
Businesses with multiple FX contracts commonly utilise net positions to decrease their chance of being margin called. The direct exposure across their forward FX positions is accumulated to create a cumulative risk setting. To ensure that positive P&L on foreign exchange contracts can help balance out exposure on others.
Margin calls are determined in a different way for forward agreements as well as net positions.
Spot Contract Vs Forward Contract
Spot and Forward are types of foreign exchange contracts which foreign exchange brokers and banks offer.
A spot contract is a current market foreign exchange rate set with one currency converted into another. E.g. GBP/EUR (converting Pounds into Euros) at a rate of 1.1005. Pounds will then be sent on or debited from an account and converted at the agreed rate.
A forward contract allows an individual/business to set a spot rate for a deliverable date in the future Eg GBP/EUR (converting Pounds into Euros) at a rate of 1.1005, but for example payable in one year. A forward contract’s benefit is that the business or individual locks in all future costs and avoids any market volatility. Typically, a deposit will be required to lock in a forward exchange rate, and execution dates can be set a few days or up to a year in the future. Forward contracts are typically used when rates are high or if the base currency (in this example, GBP) is expected to weaken.
Future Contract Vs Forward Contract
Forward contracts and futures contracts are essentially very similar to each other there are some subtle differences. A forward contract is agreed by two parties who agree on terms which include an execution date, an exact amount of currency and what currency will be delivered.
A futures contract, however, is traded on an exchange and made up of a standardised contract. A fixed maturity date is applied to a future contract, and changes are settled day by day. As they are traded on an exchange, they are guaranteed by a clearinghouse. Therefore, significantly lowering the risk of default.
How to account for forward exchange contracts?
Forward foreign exchange contracts can be used by businesses to reduce potential foreign exchange losses and mitigate risk when purchasing or selling overseas.
As an example, to account for a spot and forward contract, please see examples below.
A business receives a euro payment of €200,000 from one of its clients for payment of goods. Upon the day of invoice EUR/USD was Calculated at 1.20 ($240,000), the rate has now fallen to 1.18 and €200,000 is worth just $236,000 meaning the business loses $4000 purely down to FX movement between invoice and settlement.
However, with some foresight, let’s imagine the same business had fixed a forward contract when EUR/USD was at 1.25 to benefit from a high rate. Knowing that they were shortly invoicing €200,000 for goods, at which point the invoice was calculated at an exchange rate of 1.20 meaning they have immediately gained in EUR/USD movement.
€200,000 converted at 1.20 equating to $240,000. However, the business fixed at 1.25 equating to $250,000, meaning $10,000 is gained due to currency pair movement.
What Is the Purpose of An Option Contract?
As with a forward contract an option contract allows a business to fix an exchange rate for a deliverable date in the future, this typically ranges from a few days to 24 months. The option contract allows said business to either remain at the pre-agreed forward contract rate or if the market has moved in their favour take the option of trading at a better rate. The benefit is that the business knows the cost of their goods or transfer and can improve and gain from a favourable foreign exchange rate movements if feasible.
