Forward contracts enable you to reserve a price for buying or selling currencies on a specific date in the future. The price you lock in is determined on the day you agree the amount and settlement date for the forward contract. Forward contracts are particularly useful for businesses that have future payments or receipts in foreign currency because they allow you to protect your budget and profit margins. They can be an important part of a company’s hedging toolkit because they remove any concerns over the unpredictability of currency markets, enabling you to focus on running your business.
Unlike spot contracts, forward contracts can be seen as a ‘buy now, pay later’ arrangement that helps protect you against adverse fluctuations in the currency market. Let’s say, for example, that you know your company needs to purchase goods in six months’ time and those goods will cost you $1 million. Now, the price of $1 million in sterling is entirely dependent on the GBP/USD exchange rate at the time of purchase.
You have done all of your costing, pricing and budgeting and have worked out that purchasing $1 million at the current exchange rate of 1.4000 (GBP/USD) will cost you £714,285. However, in six months’ time when you come to actually buy the dollars, the exchange rate is now at 1.3200 (GBP/USD). That same $1 million will now cost you £757,575. That represents a loss of £43,290 and could have a direct impact on your profits, margins and bottom line.
However, by using a forward contract you can lock in a rate for the future and remove any uncertainty over the cost of goods six months from now. Obviously, in the example above we have cited an instance where you stand to lose – and it’s certainly worth pointing out that the market could move in your favour and $1 million could cost you less in six months’ time. However, can your business afford to take that risk? The peace of mind that comes from locking in a rate for the future – and the certainty you gain as a result – makes the business of costing and budgeting much more straightforward.