Want to do business globally without fear of foreign exchange volatility? If so, you probably want to learn more about forward contracts.
Forward contracts enable businesses to mitigate currency risk during the foreign exchange process. (Don’t worry; we’ll give you a more explicit example shortly!) The concept of a forward contract is relatively simple; however, if you’re a small-to-midsized (SMB) business that takes advantage of online international transactions, understanding how forward contracts work is necessary for today’s global economy.
In this article, we’ll briefly cover everything you need to know about forward contracts, including:
- What is a Forward Contract?
- What’s the Purpose of a Forward Contract
- Advantages of Forward Contracts
- Disadvantages of Forward Contracts
- How It Works: Case Study
- What Type of Businesses Use
- Forwards Contracts?
What is a Forward Contract?
A forward contract is a contractual agreement between parties that sets a fixed foreign currency exchange rate for a transaction occurring at a specific time in the future. In most cases, the two parties set this date upon the conclusion of a buy/sell transaction of goods.
Three main factors determine the terms and agreements of a forward contract:
- Exchange spot price: The rate of a foreign exchange contract that a buyer expects to pay for foreign currency in another currency.
- Interest rate differentials between the two currencies: A measure of how money from two countries compares.
- The length of the contract: Depending on market predictions, the longer the timeframe between initiating the contract and completion of the sale will affect the rate of the final transaction.
For reference, forward contracts are also known as currency forwards or FX forwards.
What's the Purpose of Forward Contracts?
There are several purposes of forward contracts:
- Lock in an exchange rate between two currencies to minimize currency risk
- Establish expectations between international parties
- Forecast accurate billing and budgeting for each party
- Protect the buyer and/or seller against unfavorable currency exchange rate occurrences a) when a sale is contracted, and b) when the sale is completed.
Forward contracts are private agreements between the parties involved, which means that they can be tailored to fit each party’s needs, including the agreed-upon exchange rate and the time frame that the contract covers.
Advantages of Forward Contracts
Forward contracts can be invaluable when conducting business abroad for business owners, C-suite executives (such as CEOs and CFOs), controllers, treasurers, and accounts. Some advantages include:
- Certainty for the buyer regarding the cost of a future purchase
- Protection against market volatility, such as inflation
- Customizable to the exact requirements of the client
Disdvantages of Forward Contracts
Despite all of the benefits of forwards contracts, there are a couple of drawbacks that you should be aware of:
- Some businesses may be unwilling to enter an agreement if they hold a favorable currency position.
- Clients are bound to honor the contractual obligation and may not be able to benefit from favorable movements in currency prices.
- If international markets significantly move against the client, bank, or broker, margin requirements may adversely impact the borrower’s cash flow.
What Types of Business Use Forward Contracts?
Forward contracts are typical between importers and exporters headquartered in different countries.
Some of the most common industries that use forward contracts include:
- Precious metals/stones
- Natural gas
- Food suppliers/processors, such as beef and coffee
- Legal and accounting
With international trading becoming more common, virtually any business type or industry can enjoy the advantages of forward contracts with Worldesk.
How It Works: A Case Study
A swimwear company based in the United States plans to sell €1 million of product to a European company and receive the revenue in 6 months. The US business is concerned that USD could strengthen against the euro and subsequently reduce the value of its exports. The US business enters into a forward contract with the European company to sell €1 million in 6 months to lock in the rate at $1 = €0.87 and protect its income.
Six months later, the spot price of one US dollar is €1.00; the company will benefit from the contract. If the dollar has dropped to €0.80 in that same time frame, the company will lose out under the contract by receiving fewer dollars for the euros than it would have at the spot rate.
As you can see, forward contracts are beneficial financial contracts that make conducting international business more transparent and more resilient against market volatility.
At Worldesk, a leading fintech solution for currency management and automation, we successfully helped businesses navigate a volatile international marketplace. With full transparency and all the tools at your disposal, Worldesk is a trusted provider of software that helps companies manage and automate their international transactions. Learn more about Worldesk today.