FX Forward Contract to Safeguard your Overseas Transaction

FX Forward Contract :



As per the financial terminologies, FX forward contract is and agreement that put legislation for an investor to exchange one currency with other at a specific exchange rate (forward exchange rate) , in a specific amount (transaction size) and on a specific date (maturity or expiry date).



It is also known as currency forward contract or simply forward contract. Forward contract or forward exchange rates is introduced in the forex market with a sole purpose of currency hedging. The maturity period of this agreement can be of 1 month,2 month, 3month or even a year, depending on the situation of investor and dealer. It is to understand how forward contracts help traders to hedge their money, let's see one example:



Say X company of US agreed to sell its products to Y company of Canada. The purchaser Y company from Canada is asking for a credit of 60 days and have informed you that the payment will be delivered when the goods from company X will be received and checked. The total amount company X will receive is $1,000,000 CD. Both the companies agreed to complete the transaction after 60 days. To secure the exchange rate company X booked Canadian dollars from bank Z for 60 days by exchanging US dollar. Once company X receive payment from company Y, it exchanged Canadian dollars to US dollars with the bank Z.



Case when company X has not opted for FX forward contract :



Let's assume that the spot rate for CD was 1.5 when company X bought $1,000,000 CD. According to this spot rate, company X has to pay $666,666.66. After 60 days of booking spot rates changed to 1.6. As per this spot rate, company X is supposed to get $625,000.00. This is how the company X incurs the loss of $41,666.66.



Case when company X has opted for FX forward contract :



The spot rate for USD and CD exchange is 1.5 in the market. And the bank z offer the contract rate of -0.0015. Thus, company X got the exchange rate of (1.5-0.0015) 1.4985. At this rate, company X will get $6,673,34.00. And even if the spot rate for USD/CD gets changed, you need not to worry about it you can get the money at your locked rate. This way choosing forward exchange rates or FX forward contract, trader can protect his transaction from market risk and money loss.



However, in above case when company X has protected its business deal from the negative movement of exchange rates, it may happen that it miss the opportunity of gaining good sum from positive market movement. If the exchange rate of USD/CD at the time of settlement is 1.4 then company X may loss profit of $46,951.714 ($7,14,285.714 -$6,673,34.00). But forex is highly volatile market thus it is difficult to forecast the value of exchange rates. For businesses security of their fund is first priority than gaining profits. Especially when any trader is transacting with large amount, he/she often chooses to hedge currency or its hard earned cash via forward exchange rates.



Donald Kershner has made a thorough research on hedging methods like FX forward contract. He has shown the benefit of forward exchange rates for businesses.