If you want to hedge your currency exposure a currency forward is one of the simplest and most accessible ways to do so.

currency forward basically means that you lock in the currency exchange rate for up to a year in advance. A small deposit is required to cover an currency fluctuations before you pay for the full amount on settlement.

But what are the mail forward exchange contract advantages and disadvantages?

Forward exchange contract advantages

The advantages are clear, the most obvious being you can stop things costing you more, or make sure you don’t lose out on foreign currency due at some point in the future.

  • Buy now, pay later
  • Lock in the current exchange rate for a future purchase/receipt
  • Hedge your exposure and reduce your risk
  • Very simple to set up
  • Inexpensive to maintain
  • You can draw down to get currency early
  • You can rollover f you don’t need funds until after the original settlement

Forward exchange contract disadvantages

The main disadvantage is of course hindsight.  One thing to bear in mind when looking at currency risk protection is that hedging can work against you. However, there are only a few disadvantages, compare to the protection that a currency forward provides.

    • If the currency moves in your favour you have missed the gains.
    • Small deposit required still ties up capital

Forward contract hedge example

Here is a forward contract hedge example that demonstrates how a currency forward can be used.
In this example we will look at a UK based business who’s European subsidiary will be receiving EUR 750,000 for a new contract and how a FX forward can be used to hedge the exposure.

The EUR 750,000 will be main in monthly instalments over the next 12 months and is guaranteed revenue.

In this forward contract hedge example we will assume that the company has budgeted in their profit forecasts based on the current exchange rate so they need to hedge the EUR 750,000 exposure in case the GBPEUR rate moves against them.

  • This can be done by a series of currency forwards to settle in monthly intervals.
  • This means that each month the company will be able to convert EUR 62,500 into GBP at the exchange rate on the day the contract was signed.
  • Enabling them to accurately budget their profit forecasts.
  • If the exchange rate moves against them they do not have to worry about a decrease in profits.
  • However, as it is a hedge they will not benefit if the exchange rates moves in their favour over the course of the year.

Here is an example of an forward exchange contract example and how it can be used by individuals and businesses.

We’ll look at two scenarios here. Firstly an example of how a forward exchange contract can be used to help protect a couple by a holiday home abroad. Then an example of how a forward exchange contract can be used to protect a businesses profit margin when ordering goods from abroad.

Personal forward exchange contract example

In this scenario a couple are buying a holiday home in Italy for EUR 500,000.  The couple have agreed a price with the seller in Italy, but the money does not need to be paid for another 6 months.  However, the couple are worried that the GBPEUR exchange rate may move against them and therefore cost them more.

  • At the current exchange rate of 1.1755 (1/2/17) buying EUR 500,000 would cost £425,350.
  • However, if this rate moved to 1.1149 in 6 months time then EUR 500,000 would cost them £448,000.
  • This is only a move of 4.5%, if you look at the 3 month GBPEUR chart you can see this is quite possible.
  • In this case had the couple locked in the current exchange rate they would have saved £22,650

Business forward exchange contract example

In the same respect a business must protect itself from adverse currency moves.  If a business buys goods from Italy with a few to selling in the UK they can lock in the current exchange rate to protect profits.

In this instance we shall use the same figures to demonstrate how a currency forward can protect a businesses profit margin.

  • At the current exchange rate of 1.1755 (1/2/17) buying EUR 500,000 would cost £425,350.
  • However, if this rate moved to 1.1149 in 6 months time then EUR 500,000 would cost the business £448,000.
  • This is only a move of 4.5%, if you look at the 3 month GBPEUR chart you can see this is quite possible.
  • In this case if the business was expecting to make a profit margin of 10% on the sale of imported goods the adverse currency move would have in effect halved their profits.

Of course, one of the disadvantages of currency forwards is that if the exchange rate moves in your favour then you do not benefit. However, when it comes to hedging currency exposure and risk management it is very easy to protect yourself from losing money, but very difficult to predict where the markets are heading for profit.

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