Foreign Exchange Forward Contracts: Minimizing Forex Risk
Whether you are counseling a small company expanding internationally or an individual purchasing property overseas, guiding clients through international business transactions can provide an opportunity for growth and higher profits.
As those in the payments industry know, with that opportunity also comes risk, as your client will now be entering the foreign exchange market (FX). Dealing in currencies outside of one’s home currency is challenging. Even the most stable currencies fluctuate; many economists would argue that there is no such thing as a stable currency. If your client plans to participate in a large business transaction in a currency other than your home currency, either as a buyer or a seller, currency fluctuation can be the difference of thousands of dollars. These fluctuations can make budget planning nearly impossible, or worse, can cause unpredicted costs or losses. Fortunately, there are solutions to help a company mitigate currency risk. One option to consider if your client is planning to make an international purchase in the future is a foreign exchange forward contract.
What is a Forward Contract?
A foreign exchange forward contract is a private, binding agreement between two parties, in which the first party agrees to purchase a certain amount of currency from the second party at an agreed upon exchange rate. The purchase will take place in the future, and will value the currency at the previously agreed upon exchange rate, regardless of the current exchange rate. In essence, the currency forward freezes the exchange rate, and that exchange rate is honored on the scheduled date specified by the forward contract. The length of the contract can be anywhere from several days to months, or even years. A currency specialist will offer forward contracts to companies or individuals dealing with business transactions involving multiple currencies. Both parties agree to an exchange rate at a future date. A deposit is normally required Length of contract can be anywhere from days to years.
Forward Contracts Simplified
Even if the exchange rate changes in a way that does not favor you or your business, the currency forward guarantees protection from that fluctuation. The forward contract ensures that you will pay the amount you planned on spending six months prior to today’s payment.
In addition to managing unprojected costs, your company now knows the exact amount being spent on your future financial transaction, allowing for more meticulous budgeting, the cornerstone of any successful business.
While there is potential for the exchange rate to later change in your client’s favor, by using a foreign currency forward contract, your “loss” will already be accounted for, as the company has already budgeted for the amount stipulated in the contract. Should the opposite occur, and your home currency loses value, you will save money by purchasing foreign currency at the exchange rate agreed upon in the contract.
How is a Forward Priced?
Because a forward is a private agreement, banks and currency specialists might use different formulas to calculate a forward price. Generally speaking, however, a forward price is determined by the current rate of a currency (spot rate), the interest of both currencies (forward points) and the length of contract (time). This is in addition to the fees charged by a bank or a currency specialist for a forward contract.
Why Interest Is Taken Into Account
To those without a background in finance, it may seem confusing that the interest of a currency is calculated into a forward price, given that the reason for taking out a foreign currency forward contract is to protect your or your company from currency volatility.
It is important to remember that money can be invested and in the future will be valued higher, which means that in the potential of investment needs to be taken into account when talking about currency over time. Interest rates reflect this change, and thus, interest rates are calculated into the forward price.
The forward price tends to rise with more mature (longer) contracts.
A Longer Contract is a Higher Price
Beyond calculating interest and the current price of currency to determine forward price, the length of time between initial engagement and scheduled purchase date is taken into account. This is why the forward price is likely to be different for a one-month contract and a six-month contract.
Because forward contracts are private agreements, in addition to interest rates, other factors are calculated into the forward price, such as the projected GDP growth of a country, the political climate of a country or how many forward contracts a currency specialist or bank already hold for the specific currency exchange you are requesting.