Forward Contract- Important Features and How does it work?

Forward Contract- Important Features and How does it work?

01 Aug 2019 05:35 PM
 

Forward contract is one of the most straight forward currency hedging methods. They are basically traded “over the counter” (OTC) between two parties, rather than through a public derivatives exchange. The contract cannot be traded in a secondary market and each party is committed to the currency exchange on the contract’s expiry date.

The different types of forward contract include window forwards, long dated forwards, non-deliverable forward and fixed forward contract. Window forwards relate to contracts that take place at any point between two set dates and the long dated forwards (More than a year up to 10 years), non-deliverables forwards (in which the difference in value between the two currencies is delivered rather than the currency itself) and fixed forward contract which allows ones to agree an exchange rate today, for a fixed amount.

Important Features of the Contract

  1. It is a private binding agreement between each party in the deal
  2. They are bilateral contracts and hence exposed to counter party risk
  3. Unlike future or options, it does not trade on a public exchange
  4. Forward contract is customizable to any commodity, amount and delivery date
  5. Each parties involved in the contract agrees on a set exchange rate or commodity price
  6. It implies that users cannot take advantage of favourable shifts in asset values.

Forward Contracts- How Can it be Determined?

Assume that an Indian company recently acquired equipment from a Japanese technology company and for the purchase it has to pay 55,000,000 Yen in 60 days. To hedge against foreign exchange risk in the next two months, the Indian business decided to enter a basic forward contract. The forward contract states that the Indian business will purchase 55,000,000 Yen from bank in 60 days at the current spot rate.

If spot rate becomes unfavourable at the delivery date, the Indian business will have hedged against its losses because it secured a more favourable exchange rate with its bank and the Japanese company will also receive its full payment. Conversely, if spot rate were to become more favourable after 60 days, the US Company would not be able to profit from the exchange rate movements because it is obliged to fulfil the forward contract with its bank.

As far as the feature of a contract is concerned, for the commodities they are similar. A small scale coffee farmer for instance might plan to export coffee to a roasting company at $6 per pound, but expects the price of coffee to go down in the near future.  To hedge against potential loss, the farmer might sell a forward contract to the roaster at $6 per pound. If the market price drops to $4.50 a pound, the farmer earns more than if the coffee sold at the market price.

Forward Rate is Different from Current Exchange Rate

Forwards rates are fixed on the basis of the prevailing rate. However, the rates are adjusted for the difference in the interest rate between currencies involved. 

Both buyer and the seller agree on a rate set in advance at the time of the contract and this rate remains fixed until the maturity of the contract.

Fixing Exchange Rate with Forward Contract

One of the greatest advantages of this contract is the measure of certainty it provides in relation to foreign exchange transactions. In case the market levels dip in the future, importers and exporters can rest assured they are secure from witnessing potential losses.

Further, knowing how much currency one will be buying or selling will help one plan ahead and budget more effectively.

Most Importers and exporters prefer taking risk rather than going ahead with a forward contract to benefit from the market opportunity. However, this can be a profitable move only if the market moves in their favour and not otherwise. What if it doesn’t? Are they equipped enough to bear the losses if the market moves otherwise?

Despite the availability of various other products, a survey conducted by Deloitte reflects almost 92% of businesses prefer the utility of forward contract over others. Having said so, most businesses fail to avail its advantages as they are unable to identify the appropriate time to book a forward contract. They also fail to understand how they can diversify the hedging strategy.

Here is where the role of experienced Forex Advisors proves out to be immensely beneficial for businesses. It is the experts who help businesses counteract the risks of Foreign Exchange market volatility in better ways.

 How can Myforexeye Forex Risk Advisors Help Businesses?

It is the complexity to understand how businesses can hedge forex risks with the utility of forward contract. This is natural and it can indeed perplex most businesses at first. But with our adept guidance we ensure businesses get the following benefits-

  1. Help protect organization’s margins by securing fixed exchange rates based on current market conditions for future foreign currency payments.
  2. Avoid getting caught up by the adverse effects of foreign currency exchange rate fluctuations
  3. Assisting businesses scheme out more accurate budgeting and forecasting
  4. Making use of forward contracts along with spot payments to take advantage of the best rates

For any kind of corporate forex risk management, forex trading, transaction process outsourcing and many other valuable services, feel free to get in touch with us

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