Whether you're running a multinational corporation or simply exchanging currency for a purchase overseas, understanding the impact currency fluctuations have on your exchange rate is paramount, especially if you’re operating with a strict budget.
That being said, it takes more than simply understanding the market to make the most out of your dollar. While there are many foreign exchange solutions available to help you minimize risk and maximize savings, forward contracts may be the solution most worth your time. With this in mind, we’ve put together a quick guide to help you determine just what forward contracts entail, and the major pros and cons you should weigh when deciding if it is right for you.
What are Forward Contracts?
Forward contracts are agreements to lock in a prevailing rate of exchange for a set period of time, usually up to two years. These types of contracts are used by financial institutions to help hedge against uncertain market fluctuations. Forward contracts may be helpful when the market is particularly volatile or if you operate with tight cash flow or budget restrictions.
What is the Difference Between a Spot Contract and a Forward Contract?
As mentioned above, forward contracts are agreements to buy foreign currency at a set price in the future. This differs from spot contracts which refer to the purchase of foreign currency at the current market price. When a company or individual wants to procure currency immediately, they opt to purchase at the spot price in exchange for instant delivery.
How Do Forward Contracts Work?
As with many other currency tools, the principal reason to enter into a forward contract is to reduce the possibility of an adverse fluctuation in your desired exchange.
For example, imagine ABC Manufacturing has a small office located in Germany, to which they send 100,000 euro monthly for payroll expenses. ABC Manufacturing has budgeted an exchange rate of 1.2500 euro for the second half of 2021. Following an interest rate hike by the Federal Reserve, ABC company was informed about the dollar’s rally to a rate of 1.2400 against the euro. ABC Manufacturing then purchases a six-month forward contract over the duration of the six months for 600,000 at a rate of 1.2425, paying only a 10% deposit. With this, ABC Manufacturing can draw down 100,000 euros each month for the next six months without having to worry about changes in the euro rate impacting their budgeted payments to Germany.
While helpful in these cases, there may be times when the rate simply holds steady or even drops. If this happens while the forward contract is in place, the company will likely lose revenue as they could have exchanged the currency for less on the open market. However, even in unfortunate cases such as these, knowing exactly what you will be paying per month, especially so far in advance, can make forecasting and financial planning much easier in the long run.
Advantages and Disadvantages of Forward Contracts
Forward contracts come with a lot of advantages, the most obvious being that you can control your exchange rate for the future and reduce your risk. As you decide whether forward contracts are right for you, understanding the advantages available to you is key.
- Helps protect profit margins from adverse market fluctuations
- Provides budget and exchange rate certainty irrespective of future spot rate on maturity
- Contracts allow you to lock in a rate for up to 2 years
- Contracts are easy to set up and maintain
Understanding that certain risk management strategies can sometimes work against you is crucial in deciding if forward contracts are right for you. And while the advantages of forward contracts arguably outweigh the disadvantages, there are still some to keep in mind.
- If the currency market moves in your favor, you may miss out on potential gains
- Small deposits may be required to set up these contracts
The Bottom line
The foreign exchange market is constantly fluctuating with currency demand being driven by tourism levels, international trade, inflation rates, and more. With these numerous factors influencing exchange rates day-to-day, staying on top of the latest movements can be tricky. That’s why implementing proactive risk management strategies, whether you're making one payment or a hundred, is essential. Currency hedging tools, like forward contracts, can help protect your payments from foreign exchange volatility for up to two years, ensuring a more accurate projection of cash flow and revenue.
Still not sure whether a forward contract is right for you? Speak to a member of our dedicated foreign exchange specialist team to see how we can help manage your payment risk today.