In this guide we take a look at FX Forward Contracts and when they are a good idea to manage your currency market risk.
An FX forward contract is a tool for hedging against adverse movements in foreign exchange rates.
Simply, it is an agreement made today to change money at a fixed, known exchange rate at some time in the future. The ‘forward rate’ used will be today’s exchange rate adjusted slightly by the ‘forward points’ – an adjustment necessary to account for interest rate differences between the two currencies in play.
The main motivation for using an FX forward has always been to lock in advantageous exchange rates. Once locked in, money can be changed at a time of your choosing – up to three-years in the future with certain providers.
Forward contracts are extremely common in business and increasingly are being used by non-business users expecting to receive or pay large sums in foreign currency, such as those buying or selling property overseas.
Forwards are considered ‘over the counter’ derivatives and, according to the Bank for International Settlements’ most recent survey, make up around 14% of the total $5 trillion per day in FX trade volume.
A Very Forward Example
Marie is from the US but is buying an apartment in Singapore. She’ll be sending funds to complete payment of SGD 600,000 in one-month’s time. If the money were sent
today she’d be paying USD 426,000 given today’s SGD/USD exchange rate of 0.71.
Marie is worried that the value of the Singapore dollar might appreciate between now and the day she sends funds. If, for example, the SGD/USD rate were to rise to 0.74
in a month’s time, she’d face a payment of USD 444,000, or USD 18,000 more than what she’d pay today.
Marie enters into a one-month forward contract to buy SGD 600,000 with US dollars at a forward rate equal to today’s exchange rate plus/minus the forward points, which in
Marie’s case is: 0.71 + 0.0023 = 0.7123.
One month later…
Marie completes her payment with a transfer of USD 427,380 at the agreed rate of 0.7123.
Marie considers herself lucky because the Singapore dollar did strengthen and with today’s best value FX provider Marie is quoted USD 442,500. Marie has saved USD 15,120!
To protect the counterparty, upon entering into a forward contract you will need to pay a deposit – typically 10-20% of the total funds.
The deposit may vary depending on the currencies in question. Forwards involving the more stable currencies of the major developed nations, such as euros into British pounds, may require lower deposits than forwards involving emerging market currencies or currencies which have less active participation (are less ‘liquid’), such as euros into the Brazilian real or the South Korean won.
Other Characteristics of FX Forwards
- Forwards work well when definite sums are in play, with certainty over timing – when, for example, you know that you’ll be sending $50,000 in three-months’ time.
- You have to be much cleverer with forwards if hedging smaller, irregular amounts coming in at uncertain times, such as those amounts you might receive as a retailer. In these cases, forwards are not as useful.
- Unlike FX options, forwards offer no upside should the exchange rate move in a favourable direction.
- When entering into a forward contract, you are essentially making a bet on the foreign currency against the direction which benefits you. You can imagine it this way: if, in our scenario above, the value of the Singapore dollar fell, making it cheaper to buy the apartment, your on-paper “win” would be offset by your “losing bet” on Singapore dollar appreciation – a bet you made via your forward.
- Some forward providers will allow you to utilize your forward (change money) earlier or later than the originally agreed date. Readers should be aware that such adjustments to the initial forward contract must be paid for. The forward provider is, strictly speaking, ‘rolling’ you from one forward to another and, most likely, a new forward exchange rate will have to be implemented.
- Forwards, unlike ‘spot’ exchange rates, are not priced transparently.
- Any of us can compare exchange rates quoted by the bank to popular websites such as www.xe.com, or better still, use Best Exchange Rates’ comparison calculators to compare against providers of travel money and foreign currency transfers, but this is not so easily done with forwards.
- Although not particularly complex, the calculation of the forward rate may be a little beyond most people (and is beyond the scope of this article), or an inconvenience. This allows sneaky banks to easily pad their margins, or their ‘spread’ above/below the true valuation of the forward.
- Nobody would deny the forward provider a profit on their services, but too much is…well, too much. The best way to satisfy yourself that you are on the receiving end of an appropriately priced forward is to use one of Best Exchange Rates’ trusted partners.
Best Exchange Rates’ Trusted Forward Providers
Both companies are experts at what they do, which is to facilitate international payments with minimal fuss and without bogus fees or margins.