Forward Contracts and Forex Volatility

Forward contracts are often used in global trade to mitigate the risk involved when payments are being made between two businesses. For instance, a company may make a large, important sale to a foreign customer with payment expected in 60 or 90 days; or, perhaps the company has made a vital operational purchase for which it has budgeted a sizable supplier payment in the upcoming quarter. Either way, the company’s profits and future plans require certainty about the size of that payment. But the relative value of the seller's and buyer's currencies may shift many times in a 60-to-90-day window; a business could find itself receiving significantly less money than expected, or paying significantly more. Forward contracts exist as a widely used solution to counteract the risk of such foreign exchange (forex) volatility.

What is a Forex Forward Contract?

Currency forward contracts are binding agreements between two parties to trade a specific value of currencies on a certain date at a rate set in advance.¹

Imagine, for example, a U.S. biotech firm sells US$1 million in vaccines to a European buyer that agrees to pay in euros 90 days from now. But the biotech firm’s controller recalls that the euro dropped from $1.147 on 14 October 2015 to $1.057 on 30 November 2015 – a decline of more than 8 percent in only 7 weeks.^2,3 People believe such steep declines don't happen often. But consider: in mid-2016, the pound fell 10 percent against the Australian dollar in the one month from 20 June to 20 July. And during the same period, it fell 8 percent versus the euro and 10 percent versus USD. Again, in the 10 days following the U.S. presidential election on 8 November, the euro fell 4 percent versus USD while AUD fell 5 percent (and the already low pound fell less than half a percent).⁴

So forex volatility happens more often than companies conducting international trade in multiple currencies might like to believe. If such a change to the euro-USD exchange rate were to happen before the vaccine deal closes for our hypothetical biotech company, the firm’s margins might be squeezed – or even wiped out. To avoid this, the firm purchases a forward contract that locks in the current euro/USD forex rate.

Calculating a Forward Contract Price

When a bank or private currency broker calculates the cost of a forward contract, it considers the current spot price of each currency as well as adjustments based on anticipated differences in interest rates between the pair of currencies involved. These adjustments are expressed as points above or below the spot rate: whichever currency is expected to have the higher interest rate will be discounted; the lower-interest rate currency will earn a premium.⁵ The financial institution offering the forex trade also will charge a fee for the transaction.

Currency forward contracts are widely used to protect importers and exporters of equipment, finished goods and raw materials. They are sometimes used to manage a company's internal transactions with foreign subsidiaries, or to mitigate risk in a pending foreign corporate acquisition or real estate transaction. While primarily utilised by large corporations, these forex solutions are also used by small and midsized companies as well as wealthy individuals who face currency risks in buying foreign property, where transactions may take several weeks or months to close.⁶

Important Characteristics of Forex Forward Contracts

Companies can benefit from understanding several important characteristics of currency forward contracts.

First and foremost, they're private legal contracts between two parties. Both parties are committed to trade the specified currencies at the specified exchange rate on the specified date. If for some reason the international transaction being hedged falls through, the company is still on the hook for the currency trade. Sometimes, companies deal with this by creating a second forward contract that offsets the first. Of course, the financial institution earns fees on both contracts.

Second, unlike the similar but standardised forex futures contracts, forward contracts are customised to each party's needs. Therefore, forward contracts aren’t usually traded and normally conclude with the actual delivery of currency, whereas futures contracts are typically exchange-traded and close out before they mature (so currency is usually not delivered).⁷ That said, forward contracts are a sizable market – by one estimate, averaging more than £400 billion per day⁸ (or roughly AUD 680 billion). So companies that need to trade between common currency pairs should not find it hard to get rate quotes and execute forward contracts. A closely related issue: as private agreements between two parties, forward contracts aren't regulated in the ways standardised instruments are, so companies should therefore be comfortable with their counterparties.⁹

One final point: going back to that U.S. biotech firm selling vaccines in Europe, if the exchange rate moves in a direction that would have been advantageous to the firm, it has foregone that benefit by committing to a forward contract. That’s fine for companies only aiming to hedge against volatility in forex markets. But it might be an issue if the company’s primary goal is to maximise profits, the company is tolerant of the risk involved and is willing to leverage its insights into future currency exchange rates. When such currency speculation is the goal, however, futures contracts are often the tool of choice.¹⁰

Forward Contract Variations

In addition to the "mainstream" currency forward contracts described thus far, a few variations exist. Companies seeking to hedge long-term currency risks occasionally use Long Dated Forwards with settlement dates exceeding a year.¹¹ Companies that don't know precisely when a transaction will close can consider a Forward window contract, which may be settled during a short interval (such as a few weeks) rather than on a specific date.¹² Finally, when a country’s currencies aren't legally tradeable or freely convertible, Non-Deliverable Forwards (NDFs) pay the “net” difference on the settlement date between any two currencies – but they pay out in a different tradeable/convertible currency, usually U.S. dollars.¹³

 

The Takeaway:

Forward contracts are viable tools used by companies of all sizes to mitigate the forex risks that are a natural companion to any global business deal involving multiple currencies. The complexity of hedging forex risk with forward contracts may seem forbidding at first. But with the guidance of qualified forex professionals, forward contracts can be used by any company.

 

Sources

1. “Forward Contract”, The Free Dictionary by Farlex; http://financial-dictionary.thefreedictionary.com/forward+contract
2. "Historical Rates for the EUR/USD currency conversion on 14 October 2015", PoundSterling Live; https://www.poundsterlinglive.com/best-exchange-rates/euro-to-us-dollar-exchange-rate-on-2015-10-14
3. "Historical Rates for the EUR/USD currency conversion on 30 November 2015", PoundSterling Live; https://www.poundsterlinglive.com/best-exchange-rates/euro-to-us-dollar-exchange-rate-on-2015-11-30
4. The foreign exchange moves described in the two preceding sentences were calculated using the same database as in citations numbered 2 and 3.
   
5. "Forward Exchange Contract",AccountingTools.com;http://www.accountingtools.com/forward-exchange-contract
6. "How a currency forward contract offers peace of mind when moving",The Telegraph; http://www.telegraph.co.uk/finance/personalfinance/expat-money/10256383/How-a-currency-forward-contract-offers-peace-of-mind-when-moving.html
7. “What is the difference between forward and futures contracts?”,Investopedia; http://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
8. "Forex for Beginners: A Comprehensive Guide to Profiting from the Global Currency Markets, Adam Kritzer;"https://books.google.com/books?id=chlzo9MbEuIC&pg=PA46&lpg=PA46&dq=$500+billion+per+day+forward+contracts&source=bl&ots=leE9WZ7uM2&sig=W2Cw82GxW9zg74pyQvBaQjwx92g&hl=en&sa=X&ved=0ahUKEwiCvt6Vo7_PAhWr7YMKHaqFDigQ6AEIJjAB#v=onepage&q=%24500%20billion%20per%20day%20forward%20contracts&f=false
9. "Forward Contract",Investopedia; http://www.investopedia.com/terms/f/forwardcontract.asp
10. “What is the difference between forward and futures contracts?”,Investopedia; http://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
11. "Forward Contract", Investopedia; http://www.investopedia.com/terms/f/forwardcontract.asp
12. “Forward Window Contract”,AccountingTools.com; http://www.accountingtools.com/definition-forward-window-cont
13. "At A Glance: Non-Deliverable Forward Foreign Exchange Contracts, NERA Economic Consulting;"http://www.nera.com/content/dam/nera/publications/archive2/AAG_NDFs_0213.pdf