Everything You Need To Know About Forward Contracts

Posted by Sonal Mistry on 5/31/21 3:22 PM

At a time when the economy and currency rates are volatile, Forward Contracts can be beneficial to use as part of a strong FX hedging program. In fact, some studies suggest that by using Forward Contracts to manage currency risk, companies reduce earnings volatility and return on assets.

What is a Forward Contract?

Forward Contracts are a contractual agreement to buy or sell a predetermined amount of currency at a specific rate and time in the future. They are an essential and customizable hedging tool used to lock in favourable rates.

Why should we use Forward Contracts?
  • Guaranteed cost/rate to protects profit margins
  • Flexibility to rollover to a future date if funds are not needed by the original expiry date
  • Keeps working capital available

Forward Contracts guarantees your position in the market regardless of fluctuations or market conditions. There also some flexibility to make adjustments if your situation changes. Other FX products such as FX Options may be a better option if you are looking for more flexibility to walk away from the contract without penalty.

There are 5 main types of Forward Contracts
FX Outright Forward FX Time Option Forward FX Expandable Forwards FX Participating Forwards Non-deliverable Forwards

 

FX Outright Forward

An FX Outright Forward, or FX Forward, is the most common type of foreign exchange forward contract. It is a contract to buy or sell a predetermined amount of currency that locks in the exchange rate today for settlement at a specified future delivery date.

BENEFITS

  • Guaranteed cost protects profit margins
  • Can be customized to a specific currency amount and for any maturity
  • Flexibility to rollover to a future expiry date if funds are not needed by the original expiry date
  • Potentially increase return on company assets
FX Time Options Forward

An FX Time Option Forward allows you to secure the forward rate today between two currencies for a specified time (similar to an FX Outright Forward) with the added flexibility to access funds at any point in the last 90 calendar days prior to contract expiry. Partial drawdown of funds is permitted during this 90-calendar day period.

Time Option Forwards are beneficial when you need cash flow certainty and gradual access to those funds.

BENEFITS

  • Guaranteed cost protects profit margins
  • Can be customized to a specific currency amount and for any maturity
  • Flexibility to rollover to a future expiry date if funds are not needed by the original expiry date
  • Potentially increase return on company assets

 

FX Expandable Forward

An Expandable Forward is a zero-cost structure offering an enhanced strike rate relative to a forward.

If the spot rate fixes at expiry below the strike rate, the buyer is required to buy a larger amount of currency at the strike rate. It is constructed by selling a put option for 100% of notional and purchasing a call option for a notional less than that of the put option, all with the same strike rate.

BENEFITS

  • No premium
  • Enhanced strike rate relative to outright forward
  • May be suitable for companies with tighter profit margins

 

FX Participating Forward

A Participating Forward is a zero-cost structure offering full protection against strength in the spot rate while allowing to partially benefit from unlimited weakness in the underlying spot rate.

A Participating Forward offers a less favourable rate than that of an outright forward but provides downside participation in spot rate.

BENEFITS

  • No premium
  • Allows for downside participation in spot rate
  • Offers full protection should spot rate strengthen

 

Non Deliverable Forward (NDF)

A Non-Deliverable Forward (NDF) is a method to hedge exposure in currencies that cannot be physically settled in the domestic currency. They are usually used for controlled currencies or very illiquid currencies such as CNY and COP. It allows the buyer to lock in an exchange rate on any given day, similar to an outright forward, but on the close date the contract is cash settled in the domestic currency. A company may use this if they have revenues in a controlled currency they need to bring back domestically.


BENEFITS

  • Guaranteed rate during term of contract protects profit margins
  • Can be customized to your needs
  • Wide range of currencies are available
  • No physical delivery or exchange of the notional amount

 

Advantages of using Forward Contracts

To summarize, these are the benefits of using Forward Contracts as part of your FX strategy:

  • Guaranteed cost/rate to protects profit margins
  • Flexibility to rollover to a future date if funds are not needed by the original expiry date
  • Keeps working capital available

Speak with one of our Account Managers if you think you may benefit from booking a Forward Contract. Schedule a 15 minute, no-obligation consultation today to get started.

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