Overview of Forward Exchange Contracts
A forward exchange contract is an agreement under which a business agrees to buy a certain amount of foreign currency on a specific future date. The purchase is made at a predetermined exchange rate. By entering into this contract, the buyer can protect itself from subsequent fluctuations in a foreign currency's exchange rate. The intent of this contract is to hedge a foreign exchange position in order to avoid a loss, or to speculate on future changes in an exchange rate in order to generate a gain.
Forward exchange rates can be obtained for twelve months into the future; quotes for major currency pairs (such as dollars and euros) can be obtained for as much as five to ten years in the future.
The exchange rate is comprised of the following elements:
- The spot price of the currency
- The bank’s transaction fee
- An adjustment (up or down) for the interest rate differential between the two currencies. In essence, the currency of the country having a lower interest rate will trade at a premium, while the currency of the country having a higher interest rate will trade at a discount. For example, if the domestic interest rate is lower than the rate in the other country, the bank acting as the counterparty adds points to the spot rate, which increases the cost of the foreign currency in the forward contract.
The calculation of the number of discount or premium points to subtract from or add to a forward contract is based on the following formula:
Days contract duration
|Premium/discount =||Exchange rate x interest rate differential||x||
Thus, if the spot price of pounds per dollar were 1.5459 and there were a premium of 15 points for a forward contract with a 360-day maturity, the forward rate (not including a transaction fee) would be 1.5474.
By entering into a forward contract, a company can ensure that a definite future liability can be settled at a specific exchange rate. Forward contracts are typically customized, and arranged between a company and its bank. The bank will require a partial payment to initiate a forward contract, as well as final payment shortly before the settlement date.
The primary difficulties with forward contracts relate to their being customized transactions that are designed specifically for two parties. Because of this level of customization, it is difficult for either party to offload the contract to a third party. Also, the level of customization makes it difficult to compare offerings from different banks, so there is a tendency for banks to build unusually large fees into these contracts. Finally, a company may find that the underlying transaction for which a forward contract was created has been cancelled, leaving the contract still to be settled. If so, the treasury staff can enter into a second forward contract, whose net effect is to offset the first forward contract. Though the bank will charge fees for both contracts, this arrangement will settle the company’s obligations. An additional issue is that these contracts can only be terminated early through the mutual agreement of both parties to the contracts.
Example of a Forward Exchange Contract
Suture Corporation has acquired equipment from a company in the United Kingdom, which Suture must pay for in 60 days in the amount of £150,000. To hedge against the risk of an unfavorable change in exchange rates during the intervening 60 days, Suture enters into a forward contract with its bank to buy £150,000 in 60 days, at the current exchange rate.
60 days later, the exchange rate has indeed taken a turn for the worse, but Suture’s treasurer is indifferent, since he obtains the £150,000 needed for the purchase transaction based on the exchange rate in existence when the contract with the supplier was originally signed.