Saturday 20 August 2011

Introduction to Currency Forward Contract

What is currency forward?

It is a contract done between two parties wherein they lock specific rate (known as forward exchange rate) for a specific future date and buy or sell currency or asset. Currency forward contract needs to be followed by both the parties in all circumstance, no one can quit from it any time.

At the time of making currency forward contract, both the parties decide the contract expiry date which is generally within 1 year. Before this contract expiry date, they can complete the transaction at anytime.

Why to choose forward exchange rates?

Today, businesses are not bound to target market within their own country. The global boundaries are shrinking and world is becoming a global village. Many businesses have offices abroad or hire goods and services from foreign country. When you buy or sell any product or service from overseas country, you must exchange our currency with the foreign currency. Now, let's take a simple example to understand why they opt for forward exchange rates (often known as “forward rates”).  X company from UK want to import some manufacturing parts of engine from Y company of US. Y company has already informed X company that they would be able to export goods after 3 month. Today, GBP is in good condition in comparison to USD thus spot exchange rate is 1.9 but it seems that recently took place London riots will make gradual impact and currency will become a bit weaker. Forex market analysts has made predicament that exchange rate of GBP and USD will fall down in next three months. If they wait for three month and complete the transaction they will make a loss of 2 to 3% which can be in large if the total transaction size is big.

Currency forward contract is an option where you can hedge your transaction from the future negative violation of sterling. You can make an agreement for 3 months and lock one rate on which you will import the goods from Y company of US. On the contrary, if Chinese economy is not stable and a retail investor has invested in American dollars, it is the best option to hedge fund via forward rates.

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