Case Study: Forward contracts for travel companies

So what is a forward contract?

This is the easy bit. A forward contract is simply an agreement to buy or sell one currency for another at a future date, at a rate agreed today. So it's basically a spot trade, but at a future date.

• Fixed exchange rate. The rate is agreed when the contract is bought. This gives you certainty about the amounts involved regardless of any market volatility.
• Agreed conversion date. The funds will exchange between your accounts on the specified date ready to be sent wherever you need.

Why would you use a forward contract?

This is a bit more complicated and will vary from one business to another. Here's a few reasons why you as a travel business might consider using a forward contract:

• 1. Locking in supplier prices. Often you need to secure flight, hotel and other bookings months before your customers travel date. Forward contracts enable you to lock in prices early, ensuring you can offer consistent pricing even if rates change.
• 2. Improved budgeting and forecasting. A forward contract will allow you to predict your costs more accurately. This in turn makes it easier to manage budgets, forecast future revenues and develop better pricing strategies.
• 3. Margin protection and cash flow. Similar the point above, but worth calling out on it's own, a forward contract will help protect your margins against unfavourable currency movements. This in turn avoids the need for large, unexpected expenditures if prices rise due to exchange rates moving against you. This is particularly important for smaller agencies and operators.
• 4. Sell in your customers local currency. What is 450,000 ISK in USD again? At the time of writing it's $3,298.75 but I bet if you were to check now it'd be something else. The point? Nothing confuses a customer more than seeing a price in a foreign currency. They check the exchange rate on one day and see one price, then check back the next and it's changed. By using a forward contract as part of a hedging strategy you can remove all this confusion by buying ahead, locking in a rate and telling them with confidence that it's $3,300.
• 5. Buy now pay later. With a forward contract you only need to pay between 3-5% of the value of the contract upfront as a deposit (we call this initial margin) but can still lock in the rate.

Let's consider an example

Nothing hits home some dry theory like a real-world example. Here we go.

Imagine you're a travel company based in the US and plan to offer a tour package to South Africa in six months costing 250,000 ZAR.

Now let's imagine 6 months has passed and the exchange has moved to 1 USD = 15 ZAR. What might that mean to the cost of your tour package had you not bought that forward?

Wow! Either you or your customer now need to find an extra $2,775!

Of course, the exchange rate could have moved in your favour, but doesn't that feel like a bit of a gamble? With a forward contract you remove the risk and lock in your profit.

Summary

Even with just the simple example above I hope you can see how a forward contract could help your travel business. It's not just about locking in rates, it's about protecting your margins, improving cash flow and giving your customers confidence in your pricing.

And there's many other ways of using them too with drawdowns and as part of a wider hedging strategy. But maybe that's one for another blog post.

Enjoy the weekend!