What is a forward exchange contract?

What is a forward exchange contract?

Protecting against fluctuations in the currency market

While the currency markets are unpredictable to say the least, and the world is starting to come out of lockdown after the coronavirus pandemic, the volatility of the currency markets during Covid-19 highlights the value of learning about currency tools. Therefore, it may be the right time to learn more about mitigating the risk of FX fluctuations.

forward contract is a private, written contract between two parties to buy or sell assets, at an agreed set price and at a specified future date.

Forward contracts differ from futures contracts in that they are private, customised arrangements, rather than traded as standard over exchanges like the ASX or London Stock Exchange.

If you’re looking to transfer money overseas or repatriate money back to the UK, you may have come across the ‘forward contract’ as a means of protecting against rate movements in the foreign exchange market. In this article, we explain what a forward contract entails and why you might benefit from taking this approach.

 

What are the benefits of forward contracts?

With forward contracts, by fixing the exchange rate for up to two years you can avoid being caught out by any unexpected rate fluctuations that would impact the price of your transactions.

For example if you decided to buy a property overseas in Australia,  using a forward contract would give you a price based on the exchange rate at the time you saw it for up to two years (though you may have to pay a small deposit).

Doing that could ensure that you won’t be affected by any exchange rate movements when the time comes to settle it with the money transfer. It could save you a lot of money, depending on rate changes.

 

When would you use a forward contract?

A forward contract is particularly useful for major lifetime events such as:

  • Overseas property purchase or sale
  • Overseas property maintenance
  • Overseas wedding 
  • The holiday of a lifetime
  • Retirement abroad
  • Paying student or schools fees

This is because on larger sums of money, even a 1% fluctuation can have a significant impact on the amount of currency purchased. It also ensures that you can accurately plan a budget by knowing exactly how much sterling will be leaving your account and how much currency will be delivered.

 

Why is the forward rate different from the current exchange rate?

Forward rates are based on the prevailing rate of exchange, but are adjusted for the interest rate differentials between the currencies involved. Both parties are contracted to the rate agreed at the time of the contract, which will remain fixed until maturity.

 

Pros and cons of fixing the exchange rate

Pros of fixing exchange rates

The advantage of a forward contract is that it provides a measure of certainty in all foreign exchange transactions, something that be of great importance to high net worth investors. Knowing exactly how much currency you will be buying or selling allows you to plan ahead and budget more effectively. If the market takes a dramatic dip, you will be protected from any potential losses.

 

Cons of fixing exchange rates

The disadvantage is that if the market moves in your favour after you have established the contract, you will be unable to benefit from the opportunity and many prefer instead to take the risk and watch the market.

 

Lock in an exchange rate while any upturns or downturns in the market won’t affect the rate you receive. As such, you’ll know exactly much money you’ll receive when you convert money for your overseas payment. Find out more today.

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