The danger is that a lot of companies do not think about strategy but instead waste energy on timing and whether they think the currency is going up and down. This is a speculative approach and when it comes to protecting profits a more practical approach is required using the correct tools.
Identifying a company's foreign exchange exposure is the first step in creating a strategy. From that point onwards, various contracts can be used to manage the exposure carefully when sending money abroad. There are two financial instruments that are commonly used to manage FX risks, these are FX forwards and FX options.
Let's start with a Forward Contract.
A forward contract or a forward exchange contract (FEC) allows a business to lock in an exchange rate today for a requirement in the future. These are the most commonly used FX hedging tools due to their flexibility and they can easily match up with anticipated payments.
The benefit of securing an exchange rate means you will know exactly how much money you will need to make payment in the future and the contract protects the business against any currency volatility.
Forward contracts can be very useful to companies involved in international trade as they lock in a specific price to avoid volatility in the exchange rate. The party who buys a forward contract is entering into a long position, and the party selling a forward contract enters into a short position.
For example, let's say a business is importing handmade shoes from a supplier overseas and the shipment will be ready in 6 months. The company will have send money to the supplier for a fixed amount of euros . A forward contract, can fix the exchange rate now for the that payment in the future. This will offer more security to that business's cash flow and improve the ability to forecast as the company knows how much it will have to pay against that invoice in pounds already.
In the event that the euro strengthens against the pound over that 6-month period the business will have locked in an exchange rate and hedged the exposure. The downside of this type of contract is of course, if the pound strengthens further against the euro, the company has committed to that fixed rate and cannot benefit from any future gain.
Forward contracts have four key components
Asset: This is the underlying set of currencies where one is being purchased and the other is being sold. This is known as the currency pair.
Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
Quantity: This amount of currency being bought or sold.
Price: The exchange rate that will be paid on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.
The interbank spot rate can be thought of as the price of purchasing one currency for another. It is the rate at which one bank may be prepared to sell one currency to another bank in exchange for another currency.
It is used as the benchmark when comparing exchange rates, as every customer wants to transact as closely as they can to this rate.
Forward points are added or subtracted to this interbank spot rate, to determine the final forward rate. These points are calculated by the difference between the currency pairs interest rates (either positive or negative) and the length of the contract. The longer the contract the more points are added
The addition of forward points to a spot rate is known as a forward premium the subtraction of forward points to a spot rate is known as a forward discount
For example, if we have a publishing company that is in the UK, pounds sterling is their base currency. However, their suppliers are in Italy and in 9 months they have to pay their publishers in €250,000 euros.
The company decides to take out a 9 month forward contract as they have to send money abroad by a specified due date.
The interbank spot rate is 1.1650 at the time of writing and the interest rate in Italy is 0% whilst the interest rate in the UK is 0.1%.
The forward rate is 1.16048 (-45.20 points)
Forward points are deducted off the interbank exchange rate because the exchange rate factors in that the company is already benefiting from holding the higher yielding currency than holding euros over the 6-month term. The party holding the euros is already earning less interest on their position and the exchange rate must be adapted accordingly.
Buying a currency forward with a higher interest rate using a lower yield currency produces positive forward points, which will make the forward rate higher than the spot rate. However, buying a currency forward with a lower interest rate using a higher yield currency generates a negative interest, which creates a forward rate lower than the spot.
Forward contracts are easy to use and they have no purchase price but there is a contractual commitment to deliver a fixed quantity of currency on the value date. If this delivery is not possible on the specified date, the forward contract can be cancelled or extended.
FX options are an alternative to forward contracts and they offer more flexibility however, they do cost more. The cost is called the premium just like an insurance policy.
Since businesses who are sending money abroad have greater certainty of the invoices due, forward contracts tend be a more suitable option.
Types of Forward contracts
The maturity date is fixed, meaning that the currency amount can only be used on the value date on the contract.
These contracts are therefore ideal for companies that have set payment dates to send money overseas
The maturity date is optional, meaning that the currency amount can be used anytime between the purchase date and the value date by drawing down.
These contracts suit companies that have variable payment dates to send money abroad.
This allows buyers to purchase a specific amount of foreign currency within a range of settlement dates or "windows". This convenience feature makes the contract more expensive than a standard fixed forward contract.
In the example above, the publishing company can take the delivery all at once on the value date on the forward contract, or it can draw down in smaller amounts as and when needed up to the amount of the value date.
After each drawdown, the balance on the forward contract would reduce by the amount drawn.
No additional charges or fees
10% deposit in advance is required within 24 hours
If the market moves more than 10% a 5% top up will be required
A forward that is up to 6 months does not require paperwork
Anything over 6 months will require a quote, invoice or contract agreement from the supplier
Foreign exchange specialists like The Currency Club provide spot and forward contracts via an online global payments platform.
Using a consultative approach they assist businesses who are regularly sending money abroad or receiving funds from overseas by designing a foreign exchange risk management policy. From this, businesses have clarity and direction regarding upcoming foreign exchange requirements as well as complete visibility over the positions in place to smooth out any currency volatility.
If your business is making regular international payments get in touch with our team of foreign exchange experts on 0207 723 7000 or login at business page.
We have made every effort to ensure that the information published here is correct and accurate, however you should check and confirm the latest exchange rates with The Currency Club directly prior to making a decision. The information published is general and does not consider your personal objectives, financial situation or particular needs. Full disclaimer available