Feb 06, 2025 ArticlesForward Contracts
What are forward contracts?
In the realm of international business, currency exchange rates play a pivotal role in determining profitability and financial stability. However, these rates are subject to constant fluctuations, influenced by a multitude of factors such as economic indicators, political events, and market sentiment. Such volatility can pose significant risks to businesses engaged in cross-border transactions, potentially leading to unexpected losses or reduced profit margins.
To mitigate these risks, businesses often turn to financial instruments known as forward contracts. A forward contract is a customized agreement between two parties to exchange currencies at a predetermined exchange rate on a future date. By locking in an exchange rate today, businesses can effectively shield themselves from potential currency fluctuations in the future.
How Forward Contracts Work
Forward contracts are typically traded over-the-counter (OTC), meaning they are not standardized and can be tailored to meet the specific needs of the parties involved. The contract specifies the amount of currency to be exchanged, the agreed-upon exchange rate (known as the forward rate), and the settlement date, which is the date when the exchange will take place. Forward contracts offer flexible terms, ranging from one week to twelve months.
The forward rate is calculated based on the current spot rate, which is the current exchange rate for immediate delivery, adjusted for factors such as the time until settlement, interest rates and several more. Once the contract is agreed upon, both parties are legally obligated to fulfill their respective sides of the agreement, regardless of how exchange rates move in the interim.
Benefits of Forward Contracts
Forward contracts offer several key benefits to businesses engaged in international transactions:- Hedging against currency risk. By locking in an exchange rate, businesses can protect themselves from adverse currency movements that could negatively impact their profits or costs.
- Budgeting and cash flow certainty. Forward contracts provide businesses with greater certainty regarding their future costs and revenues, making it easier to budget and forecast cash flows.
- Price stability. Forward contracts can help businesses maintain stable pricing for their products or services, even if exchange rates fluctuate.
- Competitive advantage. By reducing currency risk, businesses can potentially offer more competitive prices to their customers or negotiate better terms with their suppliers.
Here's a working example
Consider an American travel business selling tour packages to Europe.
The American business prices their tours in USD, but their operational costs (hotels, transportation, local guides) are paid in EUR. Fluctuating exchange rates between the USD and EUR create budgeting headaches. If the Euro strengthens against the dollar (or dollar weakens) between the time they price the tours and when they pay their European suppliers, their profit margins shrink.
A forward contract allows them to lock in a USD/EUR exchange rate for a specific amount of Euros needed at a future date. This guarantees their cost of goods sold in EUR, allowing them to accurately price their tours in USD and protect their profit margins from adverse exchange rate movements. This certainty enables better financial planning and reduces the risk of unexpected losses due to currency volatility.
Lets take a look at the numbers...
Scenario 1. Without a forward contract and unfavorable currency exchange rate movement.
| Amount to sell | 100,000 USD |
| USD to EUR spot rate used for pricing | 0.91 |
| Sets a baseline expectation of receiving | 91,000 EUR |
| USD to EUR rate when payment due 6 months later | 0.83 (8 cents lower) |
| Amount actually received | 83,000 EUR |
| Real-terms difference | 8,000 EUR loss |
If the Euro strengthens or the Dollar weakens (USD/EUR goes down - e.g. 0.91 to 0.83), the business gets fewer Euros for their dollars, impacting profit margins.
Scenario 2. With a forward contract rate locked at 0.91
| Amount to sell | 100,000 USD |
| USD to EUR forward rate used for pricing | 0.91 |
| Sets a baseline expectation of receiving | 91,000 EUR |
| USD to EUR spot rate when payment due 6 months later | 0.83 (8 cents lower) |
| USD to EUR forward rate when payment due 6 months later | 0.91 (locked in) |
| Amount received | 91,000 EUR |
| Real-terms difference | 0 EUR |
- Even though the exchange rate was lower at the 6 month point (0.83), the forward contract locked in a rate of 0.91. Therefore, the business always receives €91,000 for their $100,000.
- Because the forward contract sets the rate, there is no profit or loss relative to that rate. The business avoided a potential loss of €8,000 by using the forward contract.
The 6-month time-frame doesn't fundamentally change how the forward contract works. It still locks in the exchange rate, providing certainty and protecting the business from adverse rate movements. A longer time-frame might make the potential for larger fluctuations (and therefore larger potential losses) more significant, making the forward contract even more valuable for risk management.
How does Flowbrite fit into all of this?
That's easy - Flowbrite offers forward contracts to both companies and private individuals. Their time length can be anywhere from 1 week to 12 months.
There are no costs of a forward contract, we only ask for a very small deposit when the contract is agreed. This deposit is then taken off the final balance when the forward contract arrives at the pre-agreed maturity date.
The different types of forward contracts we offer...
- Closed forward contracts. The contract maturity date is fixed and no payments can be made before this date from the balance.
- Open forward contracts. The contract maturity date is fixed, however payments can be made from the balance, which is known as a ‘draw down’. Meaning you can access parts of your forward contract (e.g. make payments at the forward contract exchange rate), before the rate expiry date.
If you think this is something that could help you or your business, please get in touch to discuss it with one of the team.
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