Forward Contracts: What is a Forward Contract?

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.

What is a Forward Contract? Forward Exchange Contract (FEC)

How They Work

Forward contracts are used for a payment up to 24 months in the future but without paying upfront. They allows individuals and businesses to protect themselves from currency fluctuations by securing the current foreign exchange rate as part of the forward contract, but payment is made at a later date for full amount.

A deposit is paid on agreeing the forward contract which is commonly 10% of the value of the money transfer, and 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 beneficial foreign exchange movements who either don’t yet have the capital to purchase a spot contract or who don’t require to trade yet.

Types

The 3 main types of forward contract:

  • Forward contract – where a spot rate is fixed for a deliverable date in the future, this can range from a few days to up to 24 months.
  • Options contract – similar to a forward contract where the rate is fixed for a set time but with the ‘option’ to take s better rate if the trading rate improves.
  • Futures FX contract – is a contract which specifies the price of exchanging one currency for another at a future date. Futures contracts are traded via an exchange and are typically used to hedge the risk of receiving payments in foreign currency.

Benefits

The benefits of a forward contract are protecting the value of your money transfer against negative currency fluctuation. These currency fluctuations could come about due to major 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 transferring to increases in the future, the value of the money transferred 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 the cost of an international money transfer, allowing an individual of business to plan ahead with reassurance on the value of their foreign currency exchange.

Related:  FX Solutions

Disadvantages

Just as a currency can go up in value, it can also go down. If an exchange rate is set today for payment in the future but in the meantime the value of the base currency increases or the value of the currency transferring to decreases, an individual or businesses would lose out on the opportunity to increase the value of the currency exchange.

Example

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 certain to complete.

Between now and the completion the Euro hits a six month high against GBP and the client wants to benefit from this 6 month high. The client opts to fix the rate with a deposit, eliminating the possibility of GBP strengthening and guaranteeing the amount of euros he converts, the amount of pounds he receives and the rate he trades at.

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. 

Pricing

Pricing is based on 3 points:

  1. Current foreign exchange spot rate for the currency pair
  2. Rates of interest differentials between the two currencies
  3. Time of the forward contract ranging from 7 days to 2 years

If the forward contract varied from this relationship, there would be a crucial arbitrage opportunity as investors would be able to capitalise on the variation between interest rates to trade forward contracts agreements and make a substantial profit.

Deposit

Foreign exchange brokers will typically require a deposit of between 5-10% for the majority of forward contracts the clients books.

The percentage required will depend on trading history, length of the forward contract and the currency pairs involved. Typically the longer the 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 sent on with the remainder of the transferred currency when the forward contract matures and is only held to as a guarantee as the currency is purchased upfront by the Foreign exchange broker.

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 and many foreign exchange brokers won’t offer credit on forward contracts.

Related:  Foreign Exchange Regulation & Security

Forward Contracts 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 but 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 gathered to create a cumulative risk setting, to ensure that positive P&L on some 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 are offered by foreign exchange brokers and banks.

A spot contract is a current market foreign exchange rate which can be set with one currency converted into another. Eg 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. The benefit of a forward contract 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

Whilst forward contracts and futures contracts can be interpreted as 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

Related:  Foreign Exchange Contract: Spot, Forward, Market Order

How do you 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) however the rate has now fallen to 1.18 and €200,000 is now 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 to invoice €200,000 for goods, at which point the invoice rate was calculated at 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 the business knows the cost of their goods or transfer and if feasible can improve and gain from a positive foreign exchange rate movements.

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