What is a forward contract?
A forward contract is a foreign exchange agreement to buy one currency by selling another on a specified date within the next 12 months at a price agreed on now, known as the forward rate.
The forward rate is the exchange rate you agree on today to transfer your currency later. It can be calculated based on the spot rate and adjusted to take into account other factors like the time until transfer and which currencies you’re exchanging. The forward rate you agree on today doesn’t have to be the same as the rate on the day the exchange actually happens – hence the forward bit.
What are the pros and cons of a forward contract?
Forward contracts reduce your exposure to currency fluctuations and exchange rate changes. By locking in rates now, you can plan ahead with certainty knowing what your costs will be for buying and selling overseas – particularly helpful for small businesses who need to keep cash flow predictable and easy to manage.
There is, of course, a downside. By locking in a forward rate you’re committed to it, even if the exchange rate changes in your favour meaning you could have saved money if you’d opted for a spot contract at the time you needed to make the exchange instead. To counter this, you could opt to use a forward contract for a portion of your total foreign exchange rather than all of it.
A quick example:
- Steven owns an electronics firm in the UK but manufactures some component parts in Japan and so makes a large bulk order each year, which means he needs to exchange ¥5,000,000 Japanese yen annually.
- He speaks to his Clear Currency account manager and they discuss the current spot rate for an exchange and possible forward rates, as well as examining the potential to split the exchange between the two.
- With the current rate at ¥138 to the pound, Steven commits to a forward rate of ¥136 for an exchange in six month’s time, which means he knows what his costs will be and can plan his future cash flow without worrying about currency fluctuations.
- Six months later on the agreed settlement date, Steven transfers his pounds to Clear Currency and has his yen within two working days.
The Clear Currency effect:
Keep it simple
Fix a price
A forward contract lets you fix a price today for a foreign exchange in the future.
The forward rate is the exchange rate you set for an exchange that will happen on an agreed date in the next 12 months.
The settlement date is the day you get your currency.
You may see it called a forward FX trade (the FX means foreign exchange) or forward transfer.
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