What is a currency forward contract?

What is a currency forward contract?

If you make regular international payments, you’re likely to be very aware of the impact that the exchange rate has on the overall cost

The challenge for businesses is that exchange rates are notoriously hard to predict and impossible to control. If you’re looking to maintain a tight budget or protect your margins, then one way to mitigate this risk is to take out a forward contract. We take a look at what a forward contract is and how it might help your business when making international payments. 

What is a forward contract?

A forward contract allows you to fix a prevailing rate of exchange for up to two years. (A forward contract may require a deposit.) Exchange rates can fluctuate by as much as 10% or more over a relatively short period of time. Fixing the rate means that you can develop a clear budget plan and be certain that any required payments to overseas suppliers and partners are made on time and that exchange rates don’t erode the profit margin. If you’re placing orders in advance and are clear on the cost, you can organise a forward contract for that amount and avoid any pressure on planned or advertised prices.

What are the benefits of a forward contract?

The obvious benefit is certainty. If you want to be certain of the cost or be able to plan ahead, then a forward contract gives you that reassurance. Businesses are feeling the squeeze and are wary of raising prices. At the moment, the pound is particularly volatile as the Brexit negotiations come to a head and if you can’t hold off to wait and see how the politicians work out the details, this gives you a measure of certainty. Brexit isn’t the only factor which may have an impact – everything from political news to global developments could put pressure on the value of sterling. A forward contract allows you to stick to your organisation’s budget. Just a fraction of a percentage point changing on the exchange rate can make a big difference on larger sums for overseas orders and costs and a forward contract can offer certainty.

Are there any drawbacks to a forward contract?

While a forward contract protects you if the value of the pound goes down, there is also the chance that sterling could increase in value after you have committed to a contact. In that case, you may be locked into a lower rate than the prevailing market rate when it comes to settlement. This could be considered the price you pay for the certainty of securing your budget, but it’s a point to consider with some care. There are opportunities to improve your position if the exchange rate improves. A lot depends on your attitude to how much risk you are prepared to accept – if you are risk-averse or operate with tight margins, then a forward contract offers reassurance. However, if you can withstand a little risk for the opportunity to wait for an improvement in  the exchange rate, then you may want to consider market orders that allow you to track and target exchange rates and allow you to take advantage of any subsequent gains that the pound may make . 

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