A Forward Exchange Contract (FEC) allows an individual or business to secure an exchange rate now but for settlement at a specified maturity date in the future. Usually the forward contract can be secured between one month and two years.
The key benefit of booking a Forward Contract is to protect the client against adverse rate movements in the foreign exchange market. However the main risks of booking a forward contract is that the prevailing exchange rate at maturity is more favourable than the exchange rate secured earlier when the contract was booked. However at least the individual or company can budget for the expense and be confident that the cost of purchasing the currency will not change between booking the transfer and the maturity date.
Example of utilising Forward Contracts:
A client based in the UK is purchasing a property in Spain and therefore needs to sell GBP and buy Euros. The property purchase will not complete for 3 months therefore if the client waits for 3 months to book a spot rate they are taking a risk that the exchange rate remains the same or that it becomes more favourable to sell GBP and buy Euro’s. To avoid exchange rate risk the client could book a 3 month forward contract thereby guaranteeing the exchange rate now, for settlement in 3 months’ time, thus giving piece of mind that the property purchase will not become more expensive due to exchange rate fluctuations.
How is a Forward Contract exchange rate calculated?
Forward contract exchange rates are not predictions of where the exchange rates are likely to be at a specific date in the future, they are calculated based on the interest rate differentials of the two currencies being bought and sold. Forward exchange rates will either increase or decrease from the spot rate depending on whether the interest rates of currency being held by the client is more favourable to the interest rates of currency being purchased.
GBP interest rates are at 0.75%
AUD interest rates are at 1.5%
If a client is selling GBP and buying AUD, then the forward points increase overtime.
However if a client is selling AUD and buying GBP, then the forward points decrease overtime.
Whichever party is holding the higher yielding currency until maturity will be receiving a higher rate of interest return. Therefore, the forward points are used to compensate the party holding the lower yielding currency as they will not be receiving as much interest on the funds they have bought but not yet in possession of.
Eg – a client is selling GBP and buying AUD for settlement in 6 months time. The GBP remains in the clients bank account for 6 months accruing minimal interest, while the foreign exchange provider has purchased the AUD and is accruing more interest on the funds than the client. The client is compensated for this by adding forward points on to the spot rate so the forward contract exchange exchnage rate will be higher than the prevailing spot rate.
When booking a forward contract, a deposit is usually required to secure the contract which is generally between 5% to 10%. Depending on currency fluctuations foreign exchange providers may ask for an additional deposit during the life of the contract in order to maintain the agreed deposit level and so the contract remains ‘in the money’. This is referred to as a Margin Call to protect the foreign exchange provider form the potential of being ‘out of the money’ should the client renege on the contract.
Pre-delivery and Extensions
Some foreign exchange providers allow forward contracts to be pre-delivered, which means that part or all of the contract can be settled earlier than the agreed settlement date, or extended beyond the originally agreed settled date (but normally not longer than two years from when the contract was originally booked). Should a client pre-deliver or extend then the forward points will be adjusted accordingly and could mean that the client receives a better or worse exchange rate than originally agreed depending on the interest rate yields.
A forward contract is completed once the client remits the full amount of the contract, minus any deposits, at the maturity date and settled by the foreign exchange provider.