Advantages and Disadvantages of FX Forward Contracts (2022)
Updated: May 16, 2022
Forward contracts allow you to secure a buy or sell order between two currencies for future redemption. The contracts involve booking a price on the day for a certain amount of currency and a predetermined period of time.
The most widely accessible and used form of currency risk management for businesses foreign exchange exposure can be extremely useful but has its pros and cons. In this article, we are going to look into both sides of the equation so you know exactly what you’re dealing with:
If you need a wider understanding of the foreign exchange market have a look at out our guide here.
Advantages
Knowing your costs ahead of time
Contracts with importers or exporters to supply goods or services can be over a long period of time. During this period, the currency pair that you are dealing with will most likely experience exchange rate fluctuations.
This makes it hard for pricing the cost of goods or services without ultimately knowing what the exchange rate will be at the end of it.
For importers leaving the currency to the market is in reality agreeing on a price with a supplier but knowing that the price will change for better or worse. On the other hand, exporters agree on a price with their customers but know that the money they will receive will change.
For businesses not using forward contracts, normally they would put a buffer margin on their pricing to deal with any volatility but this makes the cost to the client higher. Alternatively, they might use another hedging solution like options or futures which we cover in our article here.
With forward contracts comes the security of locking in the exchange rate on the day of booking for redemption at a future date. Ultimately allowing your business to know exactly what they should be receiving or paying for a product or service.
Allowing your business to fix prices of exchange for a given order means that you are protected against a currency pairs price dropping.
Most of the time for business the less volatility the better, fixing other elements of the supply chain ahead of time is vital to knowing your profits on a contract and to default your risk. You can now do this with your foreign currency exposure as well.
Hedging volatility
Even though the currency market is the most liquid in the world it can be prone to volatility. This can be caused by data releases, political factors and further factors. Securing an exchange rate ahead of time can help you combat turbulent moves.
Most if not everyone will remember the Brexit vote decision day and the plunge in the Pound that accompanied that. GBP vs the USD finished the day 13% lower than it started.
If you were an importer in that scenario your cost in Dollars would not change but you would now be paying 13% more GBP for the goods or services. However, clients who locked in a forward contract ahead of time would have protection against the drop in the short term.
Now of course this can work both ways, if you were an exporter and locked in a forward before the Brexit vote then your contract would have been out of the money. This is why a lot of businesses use partial hedging through forward contracts, only securing a portion of their exposure ahead of time.
Securing just a portion of your exposure allows you to have the security of the fixed rate for a certain amount whilst still leaving an amount of currency to the market which will ultimately be secured using spot contracts.
Securing a favourable rate
Have you ever been in a position where the exchange rate is massively in your favour but you don’t have the cash flow to purchase them ahead of time? Forward currency facilitates this happening with low to no deposits.
Some companies will request that you pay a 5-10% deposit on forward contracts ahead of time to protect their risks should the contract move out of the money. If your business is in good financial standing then suppliers could also grant you 0% deposits meaning you only pay when you draw down from the contract.
Not having the requirement to put up the full capital for future transactions allows you to lock in an exchange rate should it be in your favour whereas otherwise, you might have not had the option to do so.
Forward thinking
Forward exchange contract lengths can be anywhere from 1 week to 2 years in timespan. This allows you to think further into the future and plan ahead. If you have a contract time of six months, for example, forward contracts can help you plan in advance.
With contracts over the 12-month mark expect these to require further scrutiny and sign off internally by your provider due to the risk that they are taking on. It is not uncommon even if you do have a 0% deposit facility to be asked for a 5-10% deposit on these longer contracts.
Disadvantages
Margin Calls
Margin calls are triggered when the forward contract that you have put in place has moved a percentage out of the money. The provider will then request that a percentage of the contract be deposited into their accounts to cover the risk that they hold.
For example, if you book a forward contract for GBP into USD at a rate of 1.3 and the rate rises to 1.37 then the contract you booked will be 5.5% out of the money. That means that if your provider closed the contract and sold it back to the market they would be 5.5% out of pocket.
At this point, they would most likely as for a 5-10% deposit to cover the risk that they hold on their books. Providers will always have a threshold of what risk they are prepared to take on, it's always best to ask what that is before you enter into a contract.
From our experience, some providers have a wide threshold for this, up to 10% out of the money before any margin call is made but with some suppliers, this can be lower than 5%. Understanding where their threshold for margin call is vital as not to be caught out but an unexpected call for capital.
Pricing
Pricing is an interesting one with forward contracts, depending on the two currencies you are dealing with you can get a worse or better exchange rate vs the spot market. This is all to do with interest rates.
The interest rates between the two countries that you are dealing with will either be the same or slightly different. If they are different then you can make or lose the difference between those two zones.
For example, if you are dealing with GBP (Currently 0.25%) into CNY (Currently 3.8%), by the forward holding the funds in CNY you are making the difference annually between 0.25% and 3.8% on interest on the contract.
This is for a scenario where you are utilising the funds at the end of the contract, if you were drawing down throughout the contract then this rate would be lower or not priced in at all. If you were converting CNY to GBP on a forward then your contracted prices would be worse than spot.
The price will always be quoted to you in the exchange rate for the forward and these differentials will be priced in. Not all suppliers show the difference to clients and some choose to keep the margin for themselves.
If you want to learn more about who can offer these types of contracts get in touch with us here.
Overexposure
So you have booked a forward contract, you are nearly at the expiry date of that contract but can’t use the pre-booked funds for whatever reason. Due to the contract being binding once booked you, unfortunately, can’t just get rid of the contract unless in a specific circumstance.
If the contract is in the money then the supplier can sell this back to the market although due to regulations on speculative booking they most likely won’t return the profit. If the contract is at a loss and you don’t have a need for the contract then you are left with a few options.
You can either sell the contract back to the market at a loss at which point you will have to pay the supplier the difference between your contract and the spot price. Alternatively, you can roll that contract forward if you have a need for it in the future but most likely the cost to do this will make your exchange rate worse.
This is one of the downsides of forwards, you will have to pay if the contract is in a loss but don’t have the upside of gaining should you close the contract in a profit.
Conclusion
Forward contracts can be a very useful tool for your business but you also have to be aware of the downfalls of the hedging solution. Whilst being quite rigid in nature there are more fluid hedging options available in the market, however, they do come with increased risks.
We look into alternative products like futures contracts and options here.
Our team is industry experienced and would be more than happy to answer any questions you may have. We have a wide market view and can find the right solution for your business. Get in contact with us here.
