Currency Risk Exposures: How Forward Contracts Can Protect Your Business
What does moving money between different currencies do for you? Apart from allowing you to transact in multiple countries, you are also subject to the risk of currency rates moving against you. While that might sound okay, it gets incredibly risky when you're handling huge volumes of money when running a business, where even the slightest dip in value can be catastrophic.
That said, just because this risk exists doesn't mean you cannot do anything about it. Sure, there's no eliminating the risk, but for the mere fact that being able to lower the risk is a possible solution you can take, you should give it a try.
What Causes Currency Rates to Change for the Better or Worse?
Currency rates are constantly changing due to a variety of factors. Some of these factors can cause rates to change for the better, while others can cause rates to change for the worse. Here are five of the most critical factors that can impact currency rates:
Central Bank Policy Central banks can impact currency rates by changing interest rates or engaging in other monetary policy forms. For example, if a central bank raises interest rates, that typically strengthens the currency because higher interest rates offer investors more significant returns. Conversely, if a central bank lowers interest rates, it usually weakens the currency.
Economic Data Contract Work?
A country's currency is affected by several factors, including economic data. If a country's GDP grows, that can cause its currency to appreciate. Other data points impacting currency rates include inflation, unemployment, and interest rates.
Geopolitical risk can have a significant impact on currency exchange rates. For example, if there is a risk of war in a particular country, that can cause its currency to depreciate. This is because investors will be less likely to want to invest in that country if there is a risk of conflict, so the demand for the currency will decrease, leading to a fall in value.
Investor sentiment can have a significant impact on currency exchange rates. If investors feel confident about a particular currency, they are more likely to invest in it, which can cause its value to appreciate. On the other hand, if investors are worried about a particular currency's prospects, they may sell it off, causing its value to depreciate.
Central banks can also intervene in the market to buy or sell their own currency, impacting currency rates. For example, if a central bank sells its currency to devalue it, this will cause the exchange rate to fall and make imported goods more expensive. If a central bank intervenes to buy its currency, this will have the opposite effect and make imported goods cheaper.
What action do businesses take to try and minimise this risk? There are many risk management solutions a company can look into to limit currency risk exposure, but we'll go into more detail about Forward Contracts.
What Is a Forex Forward Contract?
A forex forward contract is an agreement between two parties to buy or sell a specified amount of currency at a fixed price on a selected date. The party who agrees to buy the currency is known as the buyer, while the party who agrees to sell the currency is known as the seller.
The buyer and seller are both obligated to fulfil their side of the contract, even if the underlying currency market moves against them. This makes a forward contract different from a spot contract, an agreement to buy or sell currency for immediate delivery. With a spot contract, the transaction takes place immediately, and the buyer or seller can choose to walk away from the deal if the market moves against them.
The specified price in a forward contract is known as the forward rate, and it is usually based on the spot rate of the currency pair at the time the contract is made. Generally, the forward rate is usually higher than the spot rate because the buyer is taking on the risk of the currency pair moving against them.
That being said, forward contracts can be used for transactions of any size, from a few thousand GBP to millions of GBP. They are typically used by companies with a lot of exposure to foreign currency risks, such as importers and exporters.
What Derivatives of the Forex Forward Contracts Are There?
Derivatives of forex forward contracts include options, futures, and swap contracts.
An option contract is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a selected date.
A future contract is a type of derivative contract that obligates the holder to buy or sell an underlying asset at a specified price on a selected date in the future.
A swap contract is a type of derivative contract that calls for the exchange of cash flows between two counterparties at specified intervals over a period of time. Swaps can be used to hedge against interest rate risk or speculate on interest rate changes.
How Do You Hedge against Risks with Forex Forward Contracts?
When you engage in international trade, you're exposed to the risk of currency fluctuations. To protect yourself from these fluctuations, you can use forex forward contracts.
There are two types of forex forward contracts:
- A long contract is an agreement to buy currency in the future.
- A short contract is an agreement to sell currency in the future.
You can use a forex forward contract to hedge against the risk of currency fluctuations buying a currency forward, you can protect yourself from the risk of the currency's value increasing.
Of course, how you do this will be up to your situation, and that's why it is vital to pay attention to the markets to understand what you can do to turn things in your favour.
What Are the Main Benefits of Forex Forward Contracts?
Forex forward contracts offer many benefits, including the ability to lock in a currency rate, hedge against currency fluctuations, and avoid currency exchange fees. Here are four main benefits of forex forward contracts:
Lock in a Currency Rate
With a forex forward contract, you can lock in a currency rate for a future transaction. This can protect you from currency fluctuations if the exchange rate moves against you.
Hedge against Currency Fluctuations
A forex forward contract can be used to hedge against currency fluctuations. This means that if the currency you are buying weakens, the value of your contract will increase, offsetting any losses.
Avoid Currency Exchange Fees
When you use a forex forward contract, you may avoid currency exchange fees. This can save you money, especially if you are making a large transaction.
Forex forward contracts are flexible and can be customised to suit your specific needs. This means you can choose the contract size, delivery date, and other suitable terms for your trade.
Are There Any Downfalls to the Forex Forward Contracts?
Here are four of the most notable:
Forex forward contracts typically offer less leverage than other FX solutions. This can make it more challenging to generate profits or offset losses. Forward contracts also have a limited duration, so businesses must be aware of expiration dates and rollover strategies.
Fixed Expiry Date
Unlike some other forex contracts, forex forwards have a fixed expiry date. If the market moves against your position, you will be stuck with it until the contract expires.
No built-in Stop-Loss
One unfortunate downside for forward contracts is that there's no built-in stop-loss feature. What does this mean? It means that if the underlying asset's price falls to a certain point and the contract holder is unable to sell it at a price that covers their losses, they will be forced to take a loss.
Unlike spot forex contracts, forex forwards typically require the posting of margin. This means that you will need to have some money in your account to open a position. If the market moves against your position, you could be called upon to post additional margin.
So, How Do Forex Forward Contracts Protect My Business?
When you are in the business world, there are always risks involved. You may be worried about losing money if the market changes, or you may be worried about not being able to get the products or services you need. Forex forward contracts can help to protect your business from these risks.
Forex Forward Contracts Can Protect Your Business from Currency Fluctuations
If you are selling products or services in a foreign currency, you can use a forex forward contract to lock in the exchange rate. This means that even if the market changes, you will still get the same amount of money for your products or services. This can help to protect your business from losses if the market moves against you.
Forex Forward Contracts Can Help You to Manage Your Cash Flow
If you are selling products or services in a foreign currency, you may need to wait for payment. This can create problems with your cash flow. A forex forward contract can help you to manage your cash flow by allowing you to set the date on which you will receive payment. This can help to ensure that you have the money you need to keep your business running.
Forex forward contracts can help you to get the products or services you need.
If you buy products or services in a foreign currency, you may need to pay for them in advance. This can be a problem if you don't have the money to pay for them upfront. A forex forward contract can help you to get the products or services you need by allowing you to set the date on which you will make your payment. This can help to ensure that you can get the products or services you need when you need them.
Forex Forward Contracts Can Help You to Save Money
If you are buying products or services in a foreign currency, you may be able to get a better price if you use a forex forward contract. This is because you can agree to pay a fixed price for the currency, regardless of what the market rate is at the time. This can help you to save money on your purchase.
Forex Forward Contracts Can Help You Hedge Your Risks
Finally, if you are worried about the risks involved in business, you can use a forex forward contract to hedge your risks. This means you can agree to pay a fixed price for the currency, regardless of the market rate.
As a business, there are always risks involved. Risks are always present, whether it's the risk of losing money on a bad investment or not being able to meet customer demand. One way to hedge against these risks is to use looking into FX risk management solutions. Bound offers an auto hedging platform that helps companies protect their FX Risk effectively and easily. Check out our platform today and protect yourself from unnecessary risks!