Forward Contract Explained

Navigating international money transfers can be tricky. One tool that can help is a Forward Contract. This financial instrument is a way to manage currency risk and plan your financial commitments. In this article, we’ll explain what forward contracts are, how they work, and how they can benefit you. Whether you’re a business owner or an individual, understanding forward contracts can make your international money transfers smoother and more predictable.

Understanding Forward Contracts

A forward contract is a customisable derivative contract between two parties to buy or sell an asset at a specified price on a future date. Unlike standard futures contracts, a forward contract can be customised to a commodity, amount, and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.

Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk. Because of their potential for default risk and lack of a centralized clearinghouse, forward contracts are not as easily available to retail investors as futures contracts.

Forward contracts are often used by producers and users of agricultural products to hedge against a change in the price of an underlying asset or commodity. For example, an agricultural producer who has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn might enter into a forward contract with a financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

  1. It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
  2. It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
  3. It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

The market for forward contracts is huge since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller—and are not known to the general public—the size of this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist. Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market like futures. This means that the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.

Forward Contracts in International Money Transfers

When it comes to international money transfers, forward contracts can be a useful tool for individuals and businesses looking to mitigate the risk of fluctuating exchange rates. This is particularly relevant for those making large transfers or conducting business in foreign currencies.

Here’s how it works: Let’s say a UK-based company is planning to purchase goods from a US supplier, with payment due in six months. The cost of the goods is $500,000. The company could wait until the payment is due and make the transfer at the current exchange rate. However, if the pound weakens against the dollar during that time, the cost in pounds could significantly increase.

To avoid this risk, the company could enter into a forward contract with their bank or a foreign exchange broker. The contract would specify that the company will buy $500,000 at a specific exchange rate on a specific date in the future. This allows the company to know exactly how much they will need in pounds to make the payment, regardless of how the exchange rate fluctuates.

It’s important to note that while a forward contract can protect against adverse movements in exchange rates, it also means that the company wouldn’t benefit if the exchange rate moves in their favour. For example, if the pound strengthens against the dollar, the company would still be obligated to buy dollars at the rate specified in the contract.

Furthermore, while forward contracts can be useful for managing currency risk, they are not suitable for everyone. They require a certain level of understanding of the foreign exchange market, and there is a risk of the counterparty not fulfilling their obligations. Therefore, it’s important to seek advice from a financial advisor or foreign exchange specialist before entering into a forward contract.

Pros and Cons of Forward Contracts

Like any financial instrument, forward contracts come with their own set of advantages and disadvantages. Understanding these can help individuals and businesses make informed decisions about whether to use them in their international money transfers.

Pros of Forward Contracts:

  1. Hedging against exchange rate fluctuations: The primary advantage of a forward contract is that it allows you to lock in an exchange rate for a future date. This can be particularly beneficial in times of volatility in the foreign exchange market.
  2. Budgeting certainty: By locking in an exchange rate, you know exactly how much a future international payment will cost in your own currency. This can make budgeting and financial planning easier.
  3. Protection against losses: If the exchange rate moves against you, a forward contract can protect you from potential losses.

Cons of Forward Contracts:

  1. Missed opportunities: While a forward contract can protect you if the exchange rate moves against you, it also means you can’t benefit if the exchange rate moves in your favour.
  2. Counterparty risk: There’s always a risk that the other party in the contract (usually a bank or broker) won’t fulfil their obligations. This is known as counterparty risk.
  3. Lack of flexibility: Once you’ve entered into a forward contract, you’re obligated to go through with the transaction at the agreed-upon rate and date. This lack of flexibility can be a disadvantage if your plans change.

How to Set Up a Forward Contract

Setting up a forward contract for international money transfers involves several steps. Here’s a general guide on how to do it:

  1. Find a Provider: The first step is to find a bank or a foreign exchange broker that offers forward contracts. Not all providers offer this service, so you may need to do some research to find one that does.
  2. Open an Account: Once you’ve found a provider, you’ll need to open an account with them. This usually involves providing some personal information and may also require you to deposit a certain amount of money.
  3. Agree on Terms: Next, you’ll need to agree on the terms of the forward contract with your provider. This includes the amount of money you want to transfer, the currencies involved, the exchange rate, and the date of the transfer.
  4. Deposit a Margin: Most providers will require you to deposit a margin, which is a percentage of the total amount of the contract. This serves as a kind of security deposit to protect the provider against exchange rate fluctuations.
  5. Fulfil the Contract: On the agreed-upon date, you’ll need to transfer the remaining balance of the contract to the provider. They will then make the international transfer at the agreed-upon rate.

Remember, forward contracts can be complex and come with certain risks. It’s always a good idea to seek professional advice before setting one up.

Case Study: Using a Forward Contract for a Property Purchase Abroad

Let’s consider a British couple, John and Jane, who decided to buy a retirement home in Spain. They found the perfect property priced at €300,000 and planned to complete the purchase in three months. However, they were concerned about the fluctuating GBP/EUR exchange rate.

To mitigate the risk of currency fluctuations, they decided to use a forward contract. They approached their currency exchange provider who offered a rate of 1.15 GBP/EUR for a forward contract. This meant they could lock in the exchange rate and know exactly how much they would pay in GBP for the property, regardless of how the exchange rate might fluctuate in the next three months.

John and Jane agreed to the forward contract, which required them to deposit 10% of the total amount (€30,000) upfront. The remaining 90% (€270,000) would be due when the contract matured in three months.

Over the next three months, the GBP/EUR exchange rate fell to 1.10. However, thanks to the forward contract, John and Jane were unaffected by this change. They paid the remaining €270,000 at the agreed rate of 1.15, avoiding an additional cost of around £13,636 that they would have incurred due to the rate change.

This case study illustrates how a forward contract can provide certainty and financial protection against the volatility of currency exchange rates, especially for significant international transactions like property purchases.

Forward Contracts vs Future Contracts

In the realm of financial instruments, forward contracts and futures contracts are often mentioned in the same breath. Both are types of derivative contracts that allow parties to buy or sell an asset at a specific price at a future date. However, there are key differences between the two, especially when it comes to their use in international money transfers.

A forward contract is a private agreement between two parties to buy or sell an asset at a predetermined price at a specified future date. The terms of a forward contract are customisable and may be tailored to the needs of the contracting parties. This flexibility makes forward contracts particularly useful in managing foreign exchange risk in international money transfers. For instance, a business that expects to make a large payment in a foreign currency in six months can enter into a forward contract to lock in the exchange rate now, thereby mitigating the risk of currency fluctuations.

On the other hand, a futures contract is a standardised contract to buy or sell an asset at a predetermined price at a specified future date. Unlike forward contracts, futures contracts are traded on exchanges, which means they are subject to certain regulations and standardisation. Each contract is the same size and has the same expiration date. While futures contracts can be used to hedge against foreign exchange risk, they are more commonly associated with commodities and financial markets rather than international money transfers.

FAQ

  1. What is the maximum duration for a forward contract?

    The duration of a forward contract can vary significantly depending on the agreement between the two parties involved. However, it's common to see forward contracts with durations ranging from a few months to a couple of years.

  2. Can a forward contract be cancelled?

    Once a forward contract is agreed upon, it typically cannot be cancelled unless both parties agree to do so. This is because the contract is a binding agreement to buy or sell a specific asset at a future date.

  3. What happens if one party defaults on a forward contract?

    If one party defaults on a forward contract, the other party may suffer a loss. The defaulting party could be legally obligated to compensate for the loss, but this depends on the terms of the contract.

  4. Are forward contracts only used for currency exchange?

    No, forward contracts are not exclusive to currency exchange. They can be used for any type of financial asset, including commodities, bonds, and stocks.

  5. Can forward contracts be used for any amount of money?

    Yes, the amount of money involved in a forward contract can vary widely. The contract's terms, including the amount of money, are agreed upon by the two parties involved.

  6. What are the risks associated with forward contracts?

    The primary risk associated with forward contracts is the potential for one party to default. Additionally, because forward contracts are not traded on an exchange, they carry counterparty risk, which is the risk that the other party will not fulfil their obligations under the contract.

  7. Can individuals use forward contracts or are they only for businesses?

    While forward contracts are commonly used by businesses, individuals can also use them. For example, an individual might use a forward contract to lock in a currency exchange rate for a large future transaction, such as buying a property abroad.

  8. How does a forward contract differ from a futures contract?

    While both forward and futures contracts allow the purchase or sale of an asset at a future date, they differ in several ways. Futures contracts are standardised and traded on exchanges, while forward contracts are private agreements between two parties and are not standardised.

  9. Can forward contracts be traded on an exchange?

    No, forward contracts are not traded on exchanges. They are private agreements between two parties. This is in contrast to futures contracts, which are standardized and traded on exchanges.

  10. What is the impact of market volatility on forward contracts?

    Market volatility can have a significant impact on forward contracts. If the market price of the asset involved in the contract becomes highly volatile, it could result in one party experiencing a significant loss. However, the fixed nature of forward contracts can also provide a level of protection against volatility, as the price is locked in at the time the contract is made.