What You Need to Know About Forward Contracts
The majority of currency exchange transactions are completed via a spot contract. The popular buy-now-pay-now contract is, more often than not, the most suitable option for our clients. However, it is not the only and always the best option when exchanging currencies. The other option available is a forward contract. Essentially this allows you to buy now, and ‘pay later’. The pay-later option can be up to 18 months from the date the contract is entered.
What is a forward contract?
Forward contracts allow you to secure today's exchange rate, ahead of a future purchase or transaction you need to complete and allow you to avoid the risk of exchange rate volatility and fluctuations increasing the cost of your currency purchase or losing value on the currency you will be holding and planning to sell in exchange for another currency. Ultimately it will eradicate the risk of you being affected financially in a negative way.
Another advantage to a forward foreign exchange contract is that because it is a buy-now-pay-later option, you can secure the currency you need to buy, without having all of the funds available at the time to complete the exchange. A deposit is required, typically between 5-10%, which you will need to be able to pay within 2 working days, with the remaining balance not due until the settlement date you have chosen, within an 18-month period.
One example of this is, Mr. Smith in the UK has agreed to buy a property in Spain for €100,000. All the contracts have now been signed. However, the completion won’t be for 3 months as Mr. Smith is waiting for his funds to become available in GBP from the completion of a re-mortgage, once funds have been released by his bank. Mr. Smith has looked at the exchange rates now, and the current exchange rate allows him to complete the property purchase within his budget. By securing the euros he needs using a forward contract he will eliminate the risk of the pound losing value, the exchange rate going down, and the €100,000 costing him more in pounds sterling than he had budgeted for, risking him having to dip into his savings or borrow money. Mr. Smith has enough money available now to cover the deposit amount required, making a forward contract an ideal option for him. Three months later, he has now received the funds from his bank following the completion of the re-mortgage and can complete the forward contract transferring the remaining balance due, knowing the cost of the €100,000 remained the exact same figure he agreed on 3 months prior, regardless of the inevitable changes in the exchange rates.
A second example: a business called Tools Are Us, has received an order for some goods they are importing from China, the amount due will be $80,000 US. However they won’t be taking delivery of the goods for 9 months with the payment due shortly before. They have seen that the exchange rate for buying USD with British pounds has been going against them for some time, and they are concerned if the rate continues to move in this direction, they will not be able to complete the order unless they increase the price they sell the goods to their consumers significantly, which will make them less competitive. They also do not want to pay for the currency now in full on a spot contract as it will harm the business's cash flow, with the dollars not needed for 9 months and no income from the sales of the goods being generated yet. A Forward contract will allow the business to secure the cost of the $80,000 US now at a rate of exchange in today’s market, knowing their profit margins are secured once the order has been completed with the supplier in China. Also, with only a 5% deposit needed the business’es cash flow isn’t restricted.
It is important to note that forward contracts will protect you against the risk of the rate of exchange going against you before you need to complete, but obviously the rates can also improve as well over the period of the contract. If this does happen you will still be committed to the exchange rate agreed at the time of agreeing to the Forward contract, we cannot offer you the new better exchange.
The rates of exchange offered on a Forward contract can sometimes differ a little or a lot compared to the exchange rate offered on a spot contract. The variables depend on a number of factors including the currencies you are buying and selling, the time length of the contract, and interest rates. If you would like to discuss exchanging your currency using a forward contract contact us today and one of our account managers will be happy to have a chat and provide you with the information you need to make a decision and decide if it is the best option for you.