Last week we spoke to IoD members during a lunchtime seminar about how to manage currency exposure, what affects exchange rates and what tools are available to mitigate the risk. In this article, we will discuss one of the tools available, a forward contract.
How Forward Contracts Can Protect your Profits from Currency Movements
Worldwide, regardless of their size and whether they are commonly or rarely transacted, currencies all have one thing in common – their values fluctuate; they rarely stay the same.
If your organisation is involved with international payments, the timing of the transaction can make a big difference as to whether it suits or disadvantages your business. With large sums of money often at stake, any mis-readings of market conditions can become extremely costly.
What are the benefits of a forward contract?
This is why it can make eminent sense to arrange what’s known as a forward contract. Alternative names for this are currency forward or deliverable forward – they are all basically the same thing. A forward contract enables you to fix a prevailing exchange rate for your overseas payment, removing any guesswork and protecting your business from being adversely affected by any intervening market variables.
With the cost of the international payment being locked in, you know exactly what to budget for. You can plan ahead, in full knowledge of the price being the price, with no nasty surprises along the way - peace of mind and assurance for both payer and payee.
Where a currency forward would be beneficial
Unless you are looking to “trade the market”, the priority for the majority of businesses is to reduce the risk of currency exposure. For this reason, forward contracts are frequently used as a sensible hedging strategy. As an example, where your business may be regularly engaged in paying large invoices or ordering materials from overseas, which necessitate sizeable cross-border payments.
A currency forward will safeguard these inward and outward transactions from any exchange rate movements, mitigating against market risk and volatility. In situations where there is potential market instability (as is so often the case), forward contracts offer businesses a pathway to protect profits and tight budgets.
This does, however, have potential advantages and disadvantages. Yes, the transaction will be immune from any rate drops but, if the currency in question continues to advance in your favour, implementing a forward contract will mean missing out on an even higher value than the one secured. That’s where A layered hedging strategy can help to reduce the volatility of the hedge rate. Through this approach, the overall rate achieved will be the average over all the periods covered and therefore could potentially smooth any large peaks and troughs within the underlying rate. By using a layered approach, it can protect part of your future exposure giving you peace of mind and allow you to proactively manage the remainder of your requirements.
Example of where a forward contract paid off handsomely
On 23rd June 2016, the day of the EU referendum, the GBP/EUR exchange rate stood at 1.31. The day after the result, market uncertainty saw the rate initially fall to 1.23. Things didn’t get any better. Over the course of the next two years, it never returned to the pre-referendum high.
If your business had agreed a forward contract before the referendum took place, you would have benefitted from receiving an above-market rate on international payments for up to two years.
Next Steps
Forward contracts are one of the many foreign exchange tools that are available to businesses.
For more information on forward contracts and how they can potentially add value to your business, please contact david.shimmin@mfx.im or call 01624 694722