FX Forward Contracts - The In-depth Guide
Forward contracts are one of the most widely used hedging products in the foreign exchange market. Allowing businesses to protect downside currency movement risk and effectively price contracts. Locking in an exchange rate ahead of time can be an extremely useful tool. In this article, we look at:
Currency forward contract definition
Forward contracts are hedging solutions businesses use to hedge their exposure risk to volatile market movements. Allowing them to protect their contracts against
A Currency Forward Contract (FX Forward Contract) is an agreement between a bank or currency exchange provider and a business to buy or sell currency in the future. Companies can book from 1 week to 2 years' future dated at the pre-determined foreign exchange rate. The contract is booked between two currency pairs for a specified amount of currency.
How do Fx forward contracts work?
To be able to book an FX forward contract, you need to have the following:
Amount of currency you want to book
The buy and sell currencies
Length of time you wish to book for
Once you have these in place, you need to have an agreement with a provider that allows you to buy forward contracts. These are provided by the banks and other currency exchange providers.
Conventionally you will be asked for a deposit of between 5-10% of the contract value. This is used as collateral should you default. If your company's financials and track history are positive, you could be offered 0% deposits.
When you book the contract, you can draw down the secured amount all at once. Alternatively, you can draw down smaller amounts of the overall booking throughout the duration. These funds can then be used to pay suppliers or bring revenue back from exports.
Should your circumstances change and you don’t need the FX forward, the provider grants you a few options:
Sell the Contract
The provider will sell the currency back to the market at the rate of exchange on cancellation. Resulting in either a profit or loss due to the difference in the rate at the time of booking and the selling price on cancellation.
If in a profit, the contract will purely get closed, and no gains will be relayed to you due to UK FCA regulations on speculation. If in a loss, you will have to pay the currency difference.
Extention of the Contract
If your circumstances change and you need to pay a supplier a month later than the contract expiry for example. Your provider should give the option to extend. You’ll need a valid reason for the extension and contracts can’t be extended more than a few times.
Once an extension is granted, your currency exchange rate on the contract will change. This is due to the fees involved with moving the contract forward.
Types of FX Forward Contracts
Whilst mainly serving a similar purpose, there are variations of forward contracts to be aware of. Let’s take a look:
Open FX Forward Contracts
The most used form of contract leaves you with the most flexibility. Lock-in rate for a bulk amount of currency exchange between two pairs and draw down any amount (within the bulk amount). This can be done at any time throughout the contract.
Side note: When your company enters into a forward contract, it is legally binding, making it hard to get out of unless in a profit. Options are available above.
Closed FX Forward Contracts
More rigid in structure funds are to be drawn down at a pre-determined date settlement date decided on the day of booking. You are legally obliged to utilise the whole value of the contract on the day of maturity.
Window Forward Contracts
Granting slightly more flexibility you specify a window of time in the future to use the booked funds. For example, you book 100,000 GBP into USD to be used 12 months in advance, but the contract is only useable in the last two months.
You might wonder why people would use closed contracts and window forwards? Pricing will reveal exactly why in our section below:
Currency Forward Contract Pricing
Whilst for forwards, there are no charges. Costs are hidden within the exchange rate you are quoted. Providers quote lower than their cost, which creates their profit. Pricing forward contracts depend on the following factors:
The Duration of the Forward
Your provider must conduct a currency ‘swap’ to book a forward contract. One factor that affects the price is the time duration. Depending on the currency pairs you are exchanging, this can increase or decrease your exchange rate.
The Currency Pair (Only Applicable for Closed and Window Forwards)
As providers are technically lending money to book the contract, interest rate differentials between the two countries come into play. Moving currency from a country with a low-interest rate into a high-interest rate country means you gain the interest on the end currency. The opposite would mean you lose interest, making the contract more expensive.
Profit or losses are shown through the exchange rate at booking.
Example:
Moving currency from GBP (1% interest rate) to CNY (2.85%) would mean a gain of 1.85% per annum.
Moving currency from CNY (2.85% interest rate) to GBP (1% interest rate) would mean a loss of 1.85% per annum.
Type of Contract
Generally, the interest rate profit between the two currencies is only realised if you book a closed or window forward. This is due to currency exchange providers knowing exactly when you are drawing the currency. They can then know how much interest will be earnt on the contract.
Your Provider
Banks and Foreign Exchange providers price their currency differently. That goes for spot rates and foreign currency forward contracts. There generally isn't set pricing in the foreign currency industry, and costs vary massively.
Usually, all are hidden within the exchange rate unless hidden by a nominal £5 - £10 wire fee. Take note of the exchange rate you are being quoted. How different is it from the price you see on XE. Pricing between various providers varies on forward contracts from 0.01% to 5% of the total booked value.
Make sure your provider is being as loyal to you as you are to them. Get in touch with our team here today to ensure you are being charged a fair price. Some providers are ‘authorised’ by the financial conduct authority (providing extra protection) whereas others might only be ‘registered’.
Pros and Cons of FX Forward Contracts
Like any other financial product, there are positives and negatives. We take a brief look at them below. For a more in-depth view, head to our article here:
Pro’s
Know what your cost is going to be on contracts in the future
Hedge currency exchange movement risk
Book large amounts with minimal cash flow
Securing a favourable exchange rate
Con’s
Pricing by certain providers can be high
Margin calls in large currency market movements against you (check out the article here that goes into detail)
If circumstances change and you don’t need the contract, you could be at a loss
Best FX Forward Contract Providers
It can be hard to know if you are getting the best deal with such pricing variation. Due to the obscure nature of pricing, it can be highly beneficial to seek the help of industry experts.
Funding Routes has industry experienced FX experts that show you what is available to your business in the forward foreign exchange contract and finance market. We use industry data and our relationships to get you a cost-effective hedging solution. Need 0% deposits on forwards? We know what providers offer this and their risk tolerance.
Alternatively, just want to make sure you are being priced fairly? We’re happy to show you precisely what you are being charged, free of charge.
Get in touch with our team here today.
