Forward Exchange Contract: How It Works & Its Benefits

Doing business across borders is exciting. Yet, the unpredictable world of currency exchange rates can quickly turn that excitement into anxiety. But what if you could eliminate the uncertainty and safeguard your international profits? That's exactly what forward contracts can do for your business.

This article will cover all you need to know about forward exchange contracts, including:

• What they are and how they work
• The key benefits for businesses
• Types of forward exchange contracts
• An example illustrates how companies can leverage this instrument.

Without further ado, let’s get started.

A forward exchange contract (FEC) is an agreement between two parties to trade a specific amount of one currency for another at a preset exchange rate on a future date.

This pre-set exchange rate, called the forward rate, is locked in when the contract is made, protecting both parties from market fluctuations.

FECs are versatile and can be customized to your needs. They work with various currency pairs, from major to minor, and can be set up for different timeframes—anywhere from a few days to several years.

FECs are over-the-counter (OTC) foreign exchange agreements. Unlike stocks or futures, they're not traded on centralized markets. Instead, FECs are created directly between 2 parties, typically a business and a financial intuition.

This flexible structure allows for trading a wide range of currencies, including those not commonly found on the foreign exchange market. This can include minor currencies like the Thai baht or Mexican peso, as well as blocked currencies, such as the Chinese yuan or Indian rupee.

Key Components of a Forward Contract

Every forward contract outlines 4 essential elements:

1. Currency Pair: The two currencies being exchanged (e.g., GBP/USD).
2. Notional Amount: The amount of each currency to be exchanged.
3. Settlement Date (Expiration Date): The future date when the exchange will take place.
4. Delivery Rate (Forward Rate): The preset exchange rate at which the currencies will be exchanged on the settlement date.

How to Calculate Forward Rate

The forward rate is calculated based on several factors, including:

• S = the current spot rate of the currency pair
• r(d) = the domestic currency interest rate
• r(f) = the foreign currency interest rate
• t = time of contract in days

Generally, forward exchange rates can be obtained up to 12 months in the future. However, for the four "major pairs," rates can be locked in for up to 10 years in advance.

The major pairs are:

1. U.S. dollar and euro (USD/EUR)
2. U.S. dollar and Japanese yen (USD/JPY)
3. U.S. dollar and British pound sterling (USD/GBP)
4. U.S. dollar and Swiss franc (USD/CHF)

Why Forward Exchange Contracts Are Essential for Your Business?

Foreign exchange contracts provide numerous advantages, especially when dealing with international transactions or exposure to foreign currencies.

Hedging Against Currency Risk

Currency markets are highly volatile. Foreign exchange rates constantly fluctuate due to multiple economic and political factors. These unpredictable movements can hurt your finances, disrupt your financial planning, and create uncertainty in your operations.

FECs offer a solution by allowing you to lock in a favorable exchange rate for a future transaction. This protects you from potential losses due to FX risk, ensuring greater predictability and stability in this turbulent market.

Accurate Budgeting and Forecasting

For businesses operating in the global market, precise budgeting and forecasting are crucial for making informed decisions and planning for the future. FECs provide the certainty of a fixed exchange rate, enabling you to create more accurate financial projections. This allows you to allocate resources efficiently, anticipate costs accurately, and make sound business decisions based on reliable data.

Enhancing Cash Flow Management

By fixing exchange rates for future transactions, FECs can help you stabilize your cash flows. This predictability is essential for managing your working capital, meeting financial obligations, and ensuring smooth business operations. You can confidently plan your finances, knowing the exact amount of currency you'll receive or need to pay at a future date.

Gaining a Competitive Edge

In today's market, every advantage counts. By utilizing FECs to manage currency risk, you can gain a competitive edge over businesses that are not proactively addressing this issue. This can translate to improved profitability, greater financial stability, and enhanced business resilience.

Businesses typically have access to three main types of forward exchange contracts, each offering unique features and advantages to address different business scenarios.

Fixed Forward Contracts

Fixed forward contracts are the go-to choice for businesses seeking simplicity and certainty. They lock in the exchange rate and settlement date right from the start, offering maximum predictability and shielding your business from currency market ups and downs. 

If you have specific future payment obligations and prefer to play it safe with foreign exchange risk, fixed forwards are your best bet. They're perfect for companies that like to keep their financial planning as precise as possible.

Open Forward Contracts (Flexible or Window Forwards)

These contracts offer a bit more flexibility. While the exchange rate is still predetermined, the settlement date is not set in stone. Instead, you choose a time window for settling the contract. The actual exchange rate is fixed on the day you decide to settle within that window. This flexibility can be beneficial for businesses whose payment timelines might shift a bit. You're protected from major currency swings but can adapt to slight changes in your cash flow timing.

Non-Deliverable Forwards (NDFs)

Non-deliverable forwards are a specialized tool designed to tackle currencies that aren't freely traded, due to government restrictions or limited market liquidity. Unlike standard forwards where you actually exchange currencies, NDFs are settled in cash. Here's how it works:

• You agree on a forward rate, and when settlement day comes, you compare that to the current market rate.
• The difference is then settled in a major currency, usually US dollars.

NDFs are essential for businesses operating in countries with currency controls or those dealing with less common currencies.

Example of a Forward Exchange Contract

Let's see how forward exchange contracts play out in a real-life business scenario.

The Challenge

ABC Limited: A German bicycle retailer importing from the U.S.

Bicycle Corp.: A U.S.-based bicycle manufacturer exporting to Germany.

ABC Limited is scheduled to pay Bicycle Corp. USD 10,000 on 30 September 2024, for a shipment of bicycles. However, Company A is concerned that EUR/USD exchange rate could weaken by then, making the bicycles more expensive for ABC Limited.

The Solution

To mitigate this risk, ABC Limited enters into a forward contract with a forex dealer. This contract locks in today's EUR/USD exchange rate for the payment due on 30 September (EUR 1 = USD 1.20). The agreed-upon rate includes a small markup as the dealer's fee.

The Outcome

By utilizing a forward contract, ABC Limited secures the value of their payment in US dollars, regardless of any currency fluctuations in the EUR/USD exchange rate over the coming months. This eliminates the uncertainty and risk associated with currency volatility, allowing them to budget and forecast accurately.

If you have a business in Asia and are looking to leverage the advantages of forward contracts, consider Statrys. We offer SMEs access to advanced and competitive FX services, helping you streamline cross-border transactions and expand your reach in the global marketplace.