What is a forward contract with example
A forward contract allows an individual or company to fix today's exchange rate for a date in the future. The benefit of doing so is to have certainty on the cost of a purchase or project meaning the risk of foreign exchange volatility is eliminated.
See below example
A property investor is needing to convert £100,000 to US Dollars as funds are required in the coming months. He consults with a broker who advises that the GBP/USD has strengthened from 1.2086 to 1.2788 in under a month. The investor fixes a price at 1.2788 and mitigates the risk of GBP/USD losing value, whilst fixing his costs.
What is the difference between FX spot and FX forward
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
How do FX forwards work
Forwards contracts are essentially a way of being able to buy a spot contract (current FX market rate) and pay later. Essentially allowing one party to fix an exchange rate for a future delivery date which can range from a few days to up to 24 months. The benefits include mitigation of future FX market risk, to protect a purchase or a business from increased costs and weaker purchasing power. A business is also able to fix their product prices if they have locked in an exchange rate as they avoid supplementary costs and erosion or profit margin.
Benefits of a forward contract
Agreeing on a forward contract helps fix the cost of your international money transfer, allowing you to plan ahead with reassurance and certainty; getting rid of any FX surprises.
This forward contract works both ways, however, as the forward contract provides you with the same agreed currency exchange rate even if the rate moves in your favour by the time it comes to settlement. Forward foreign exchange contracts are typically used as part of a hedging technique to reduce the currency exposure of your company or overseas purchases.
Deposit for a forward contract
Foreign exchange brokers will typically require a deposit of between 5-10% for the majority of forwards the book for clients. The % required will depend on a few things including trading history, length of the forward contract and the currency pairs involved. Typically the longer the contract the more deposit required. Larger corporates and businesses with a healthier balance sheet will sometimes have the 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.
Zero Deposit forward contract
Businesses with healthy balance sheets or long term trading records might potentially have the ability to lock in forward contracts without 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.
Why might you need a forward contract?
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.
Scenarios were of forward contracts are beneficial-
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.
An SME has an invoice in USD which needs to be paid in the next 2 months. The GBP/USD is weakening by the day due to economic factors. To stem the losses of the GBP and ensure that the USD rate doesn't get out of hand the director fixes the GBP/USD for 20 days to mitigate the risk of the USD invoice costing more in 20 days.
Forward contract pricing
Forward contract pricing is a fairly straight-forward principle based on 3 points. The very first aspect is the current foreign exchange spot rate for the currency pair, the second variable is rates of interest differentials between the two currencies involved in the foreign exchange transfer, the 3rd is the time of the forward contract which can range between 7 days and 2 years.
If the forward contract varied from this relationship, there would be a crucial arbitrage opportunity as investors would be able to capitalize on the variation between interest rates to trade forward contracts agreements and make a substantial profit.
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.
What is the difference between forward and future 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
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 are the types of forward contract
The 3 main types of foreign exchange forward contract are the following.
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.
What are the features of a forward contract
The key feature of a forward contract is that it allows a business or individual to fix today's spot exchange rate for delivery on a future date. It allows the individual or business to mitigate foreign exchange risk and budget for the project or purchase of items. Regardless of what happens in the foreign exchange market, the price is fixed.
Is a forward contract an asset
A forward contract is a non-standardised contract between two counter-parties. One adopting a long position, the other party a short position. A forward contract, therefore, is considered a derivative instrument.
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.
What do you mean by swaps
A foreign exchange swap is essentially an agreement or contract whereby one currency is borrowed by one party and concurrently another currency is lent to the other involved party. Both parties use the repayment obligation as collateral with the repayment being defined by a forward contract rate. Financial institutions view FX swaps favourably as they are essentially risk-free lending. They are typically adopted by importers and exporters and institutional investors who wish to hedge their speculative foreign exchange positions