How Forward Exchange Contracts Work
Forward Exchange Contracts allow you to lock in an exchange rate for a specific amount for a future date.
Forward Exchange Contract Rates
The exchange rate that is locked in is based on the current exchange rate (spot rate) and is adjusted for the time period that you need. This adjustment in the rate is called Forward points. So the Forward Exchange Contract Rate = Today’s rate +/- Forward points
Paul needs to pay $10,000 US dollars to China in 1 month’s time. Today, the exchange rate is 0.7700 but he is worried it might fall in the next month.
He enters into a forward exchange contract for 1 month for $10,000 US dollars. His rate is:
Forward Exchange Contract Rate = Today’s rate +/- Forward points = 0.7700 – 0.0015 = 0.7685
Paul is happy that he has locked in the exchange rate. In 1 month, he makes the payment online and uses the Forward Contract to make the payment using the agreed rate of 0.7685
The Most Common Myths about Forward Exchange Contracts
Forward points are a premium or the cost of the contract
When you enter into a Forward Contract, you are committing to buy a certain amount of currency in the future. What you may not realise is that the bank then needs to go out into the foreign exchange market and buy that currency for you.
The Bank will make more money if you lock in the rate and it moves against you
Everyday, banks make a profit by buying currency at a wholesale rate in large amounts and then selling it to you in smaller amounts with a margin. A Forward Exchange Contract is the same. Imagine they buy a Forward Exchange Contract for $1.00 and sell it to you for $1.04. Once you lock in the rate, so does your bank. If the exchange moves afterwards, it doesn't change the profit they made when you took out the contract.
The Forward Exchange Rate is an indication of where the bank thinks the exchange rate will go
The Forward Exchange Rate has nothing to do with any expectation of where the exchange rate will go. It is simply today's exchange rate, plus or minus forward points. See “How they work” for an explanation of how it they are calculated.
You must use all of your Forward Exchange Contract on the day it is due
Most Forward Exchange Contracts allow you to use it early (called a predelivery). They can also be extended (called an extension). Please note that using it early or extending it will change the rate you receive and are can be subject to approval by your bank or currency provider.;
Why you should or shouldn't use a FEC
Forwards contracts can be like headache tablets. They are very common and used for a variety of purposes but, if used incorrectly, they can be ineffective or even dangerous.
Forward Exchange Contracts can prove very useful when
- You have a firm commitment to buy or sell a specific amount of currency on a date in the future.
- You wish to lock in the exchange rate and will not worry if you've locked in a rate and the currency moves in your favour
- You understand how they work
You might want to consider other options if you are unsure about how much currency you'll need or when you'll need it. Forward Exchange Contracts are like any other legally binding contract. They are a commitment, so if you enter into a FEC to buy $100,000 US dollars in a month but find you only need $70,000 – there could be a cost to cancel the portion of the contract you no longer need. Also, if you want to take advantage if the exchange rate moves in your favour, then a Forward Contract might not be for you. A FEC will lock in the rate, which means for better or worse. In both of these scenarios, you may want to use a Forward Exchange Contract for a portion of your overall amount, instead of the total.
Liz has sold her house in London. She thinks she will receive around 200,000 British pounds (GBP) in 3 months but thinks the AUD/GBP rate will move down, in her favour. But in the back of her mind, Liz is concerned that it might go up, so she takes a Forward Exchange Contract for 100,000 pounds for 3 months. Her rate is:
Forward Exchange Contract Rate = Today’s rate +/- Forward points = 0.5070 – 0.0070 = 0.5000
3 months later, she uses the Forward Exchange Contract for 100,000 at 0.5000 and exchanges 100,000 on the rate of the day, which is 0.5100
In most cases, to use a Forward Exchange Contract, you will need to provide security. It is similar to putting down a deposit on a house you eventually buy. The security (deposit) is a safeguard to make sure you go through with the contract and protects the other party if you don't.
Banks can take security over an asset, like your house or business. If you aren't using a bank, the currency provider may ask for a cash deposit. Most deposits are between 10-20% of the contract value. So, if you want a Forward Exchange Contract for $100,000 US dollar, you may need a deposit of around $15,000 AUD.
The hidden costs of using a Forward Contract
As explained earlier, banks make a profit by buying currency at a wholesale rate in large amounts and then selling it to you in smaller amounts with a margin. What most people don't realise, however, is that banks may also charge a margin on the forward points too. This margin is less widely known because it's harder to work out. When you get an exchange rate, it's easy to check the rate against a website like xe.com or yahoo finance. Forward Contracts are different. When you are given a rate, you can't check if there are any hidden margins added on.