If you’re new to the world of international business and foreign currency, there are going to be several terms that you need to learn and understand as you dive in - “forward exchange contracts” is one of those terms.
Forward exchange contracts, or FEC, are a specific type of over-the-counter foreign currency (forex) transaction.
These can be used for any currency type, including the ones that are blocked, inconvertible, or considered minor.
What is a foreign exchange contract?
In order to understand foreign exchange contracts, you first need to understand what a foreign exchange rate is.
To describe it in its most basic form, it’s how many units of one currency are equal in value to a certain number of units in another currency - the one you want to convert to.
The foreign exchange rate changes regularly since currencies trade on an open market.
Foreign exchange can be as simple as going to a bank and trading out your U.S. dollars for euros when you’re spending a week in Spain.
There are also people who trade on the foreign exchange market, electronically trading money for business - and sometimes speculative - purposes.
What is a forward exchange contract?
A forward exchange contract is an agreement between two parties defining the terms of future exchange of currency at a specific time.
By going into an agreement, the parties are protected from the hard-to-predict fluctuations that the market tends to see in currency prices.
The key factor of foreign exchange contracts is that they are a hedge, used to protect against the risk of the market.
The value of currencies is constantly changing, and if you’re going to be paid at a future date for a service or for goods, you need to hedge against the market.
Forward exchange contracts are not traded on exchanges, and they can only be canceled if both parties agree to disband the contract.
Always included in a foreign exchange contract are the following:
- Currency pair, or the two types of currencies that will be exchanged
- Notional amount
- Settlement date
- Delivery rate
- What the spot rate is on that date and that it will be used on the future date
Because the rate of exchange is fixed, each party is able to plan better financially and is confident in where they are at when it comes to the yearly budget.
Forward exchange rates can be obtained up to 12 months in the future unless you’re exchanging one of the four “major pairs”.
The major pairs are:
- The U.S. dollar and the euro
- The U.S. dollar and the Japanese yen
- The U.S. dollar and the British pound sterling
- The U.S. dollar and the Swiss franc
These four can be locked in up to 10 years in advance.
If your company does international business, this is a great option to make sure you aren’t losing out on money that you weren't planning on.
Using a Forward Exchange Contract: A Real-World Example
Let’s talk about a real-life example where a forward exchange contract could be useful.
Let’s say you own a fabric company and you imported fabrics from China, Italy, and India.
You place an order on January 1st, but it won’t be finished and delivered from Italy until July 1st.
You and your manufacturing partner in Italy can set up a forward exchange contract guaranteeing that what you agreed to pay will be what you receive in July.
If the exchange rate in January is 1EUR:1.1USD, and you’re contracted to turn 100,000 euros into U.S. dollars, you’d be locked in to receive 110,000 USD in July.
If you didn’t lock it in and the rate dropped to 1EUR:1.07USD, you’re only going to get 107,000 USD.
The most beneficial transactions come from contract amounts of $30,000 or more rather than for small personal transactions since fluctuations in exchange rates are relatively small.
They’re only a few pennies for small transactions, but could be millions for a business transaction.
There are many currencies that are used in forward exchange contracts.
The most popular in order are the Chinese yuan (CNY), Indian rupee (INR), South Korean won (KRW), New Taiwan dollar (TWD), Brazilian real (BRL), and Russian ruble (RUB).
Additionally, most forward exchange contracts are done against the U.S. dollar above any other currency.
There is a specific calculation that is used for finding the forward rate in forward exchange contracts.
The factors are:
- 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
The Forward Rate formula looks like this:
Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))
Using this formula, you can plug in your numbers and come up with the forward rate for your forward exchange contract.
This is often done automatically by computers on a given exchange.
Forward exchange contracts are an extremely useful foreign exchange transaction.
They save large company’s money and help them avoid the risk from the open forex market.
By going into a contract with your supplier, or anyone, you’re protecting both parties and allowing for easier financial planning.
These can also be used for the personal use of transferring funds.
If you have a relative who is living in Europe and you want to give them a large sum at a future date, you can lock in the exchange rate now and be sure of how much your family member is getting and how much you are giving.
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