Currency Forward Contracts Hedge Foreign Exchange Exposure

Currency forward or forward contract are two major tools in terms of currency hedging or to protect the foreign currency against exposure to foreign exchange market. Investopedia defines currency forward as : the contract holders are obligated to buy or sell the currency at a specified price, at a specified quantity and on a specified future date. These contracts cannot be transferred. As far as forward contract is concerned, it is a contract in the Forex market that locks in the price at which an entity can buy or sell a currency on a future date. Forward contract is also known as outright forward currency transaction, forward outright or FX forward.

Unlike, futures contract, which trade on an exchange, currency forward contract is made and terms and conditions are discussed between the parties. If you are a business irrespective of your size, you need to consider following reasons for currency hedging :  

• Any type of hedging will minimize the present loss if any. This will directly impact the profit gains scenario
• This saves you of the constant speculation of the foreign exchange rate
• Facilitates the pricing of products sold on export markets

The foreign future and currency forward contracts like any other such contracts are traded on highly regulated exchanges across the glob irrespective of the contract sizes, time periods, and settlement procedures. In contrast to future contracts, are over-the-counter contracts and may have of different contract sized, time periods and settlement procedures. Because they are considered over the counter contracts, there is no centralized or regulated trading location and transactions are conducted directly between parties via telephone and on-line trading platforms at many places across the glob. This type of currency hedging started growing popular in 1970s, and is mainly used by big corporations and banks to minimize their foreign exchange currency rate. However, independent and individual investors or traders can also take advantage of these currency forward contracts.

Forward Exchange Rates Provide Total Currency Hedging

Investor words defines forward exchange rates as : “The exchange rate set today for a foreign currency transaction with payment or delivery at some future date.” Hence, it is rate that is decided at this moment but traders can pay it on stipulated future date at stipulated time. In a direct contrast to these rates, there are spot rates. In fact, spot rates are the rates with which transactions on foreign exchange market begins. True to their names, spot rates are the rates that are for immediate transactions.

Now, when you are sure that at a particular time and date, you need to pay certain fixed amount to buy a currency, you are in peace. This is called complete currency hedging. As everyone knows, foreign exchange market is extremely volatile and therefore, it is highly risky to trade on this market which requires day to day check. Businesses which are into international transactions often need to be vigilant about these rates and in order to avoid losses, they often have to indulge in forward exchange rates. 

If you have opted for forward exchange rates, it automatically assures you sound sleep and you will get your money as agreed upon between you and the financial services provider. In this way, it can be said that forward rates are the best solution for currency hedging. If forward contract is the one for the businesses, spot rates are the most common type of rates because it is the real time currency conversion. Once the rate is fixed with which one is going to buy the currency, it will take almost two days to complete the task. In this way, spot rates do provide a bit currency hedge, but there are no guarantees of total currency hedging in spot rates as compared to forward exchange rates.

Hedging Risk Using Forward Exchange Rates

Foreign exchange (Forex or FX) is the only market on planet where brokers, banks, big financial institutes, retail investors swap currencies in staggering volume on daily basis. Forex is highly volatile market. The currencies are changed in value at every second thus it is very difficult to keep a track on currency value. If you have invested large amount in forex currency hedging is very important aspect to protect your hard earned money from the negative fluctuation of currencies. Forex companies offer forward exchange rates and spot rates to hedge your transaction.

Exchange rate of two currencies or a pair of currency is governed by so many factors like interest rates, economical and political stability,etc. A minor change in any of this governing factor can change the exchange rate. If you have invested in more than one currency pair then also a negative movement of one pair can diminish the positive movement of others. If this is the first time you are investing in forex for business growth, you ought to know about forward exchange rates and spot rates. Spot rate should be chosen when you can finish the order within 2 days thus this is widely used by regular traders.

Using forward exchange rates or forward rates, the service provider forex company create a legal document where in two parties seller and buyer fix the rate and date of future transaction based on the current market. The period is decided on the agreement of the forex company which can be 1month, 2month,3months,1 year or anything. Based on the amount involved and the period decided to complete the order, interest is charged by forex. However, for businesses the priority is currency hedging not the profit from their investment thus paying nominal interest on forward rate is best solution for businesses. Choosing this option businesses are reducing the exposure of invested money from negative as well as positive market movement.

Forward Exchange Rates Minimize Exchange Rate Risk

What do you understand by the term exchange rate risk? It is the risk that a business' operations or an investment's value will be affected by changes in the exchange rates. Let's see one example to see how negative movement in exchange rates can be risky for traders and how spot rates and forward exchange rates minimize this risk factor.

Suppose, you have purchased American dollar by exchanging British pound or sterling. Now, the price of American dollars starts decreasing suddenly so you will not gain any profit if you sell them instead you will count a big loss. Now, you might be thinking that why we are selling the currency when the market is down? Can't we wait till the market rise again? Well, it is not always possible in the real life scenario.If you have purchased a home abroad and you have make a deal that you will pay the seller after 2 month. The time when you make this deal the rate was GBP/USD=1.054 but it falls to 20% when you actually made the payment.

Exchange rates changes at every second and impacts on retail as well as businesses who make international payments. Many forex companies are offering currency hedging service to minimize investment risk. Forward exchange rates is the rate decided between the client and the company in current date for the future payment delivery. Spot rates are also offered for currency hedging but in this service you need to complete the payment within 2 days only. Choosing forward exchange rates, you need not to worry for any negative movement in the exchange rate but at the same time you must be ready to leave profits in case the market moves in positive direction. Once the rate is locked, you are obeyed to execute your payment with this decided rate only. You will be given a specific duration like 2 month, 6month or may be 1 year to make the payment.

Forward Exchange Rates - Effective Risk Management for your Business

If you are new to forex market, you must be wondering  what are spot rates and future or forward exchange rates? Whenever currency conversion takes place such terminologies are often used. What do these terminologies mean? Spot rates are the rate of currency exchange at the moment, and fluctuate quite a bit over the course of a day. Whereas, forward exchange rates are rates that are quoted today for delivery and payment on some specified date in the future. No currencies change hands on the date the contract is signed for forward exchange transactions. Forward exchange rates and spot rates are actually two methods of trading currency in forex market.

Let's understand Forward exchange rates (also called forward rates) method. In Forward rate contract, two parties made an agreement and fix the currency exchange rate for the transaction which going to be held in the future. Forward rates provide 100% currency hedging for your earned money. The forex company has a team of market analysts who research on the all the factors governing currency rates of the different countries. The major six factors are inflation, interest rates, speculation, change in competitiveness, relative strength of other currencies and balance of payment.

Foreign exchange companies continuously monitor all these factors and design a model which can predict the currency rates of future. Most of the foreign exchange companies are in colloboration with the international banks. Thus they buy foreign currency in a large size at the fix rate. Even if the market foreign exchange rates gets fluctuated thenafter forex companies can still offer best deal for your business transaction. If you have signed a forward contract and locked a rate for the future transaction, you can complete your transaction at any time within the decided period in agreement. Business transactions involves large amount thus currency hedging is a key consideration for overseas money transfer.

Introduction to Foreign Currency Forward Contract

What does foreign currency forward contract mean?  Currency forward contract is an agreement between two parties to exchange two currencies at a fixed currency exchange rate at some point in the future but within 24 months.  There are number of foreign exchange (Forex) services provider companies who offer currency forward services to their clients. But the question may arise in your mind that why one would need this service. Every nation has its own currency rate which represents the economy of the country. These currency rates are governed by many economical factors which continuously changes and in result currency rates changes. Trader exchange two currencies and currency exchange rates changes at every second thus it becomes very difficult for him to predict about the changes in value. Even a small change in currency exchange rate can put trader in a big loss. Thus, the demand for currency forward service is increased.

Currency Forward services provides the perfect business solution for all who want to make international payment. As per currency forward agreement, two parties client (can be a trader or any individual making an overseas payment) and the forex company lock one currency exchange rate for the future transaction. Thus, sometimes it is also known as currency future contract. By opting for currency forward service, one needs not to worry about the fluctuations in currency exchange rates. Client is given a specific period within which he can make the payment at any time provided the exchange rate will remain same as decided in the agreement. This way, client is getting currency hedging service.

Currency hedging offered by the forward contracts agreement not always means that you are protecting your transaction from the possible loss but it may also possible that currency exchange rate of the currencies you are trading increases at the time you make the payment and you may loss a good amount of profit. However, it is better to loss some profit than to incur big losses.

Which is a Best Deal? Forward Exchange Rates or Spot Rates?

Use of correct strategy and proper money management techniques has delivered a great success to many businessmen who are involved in forex market. Businessmen who often buy or sell currency or assets take assistance of online forex company. With the help of such forex company, every businessman executes overseas transaction with currency hedging. The term “currency hedging” is quite familiar to those involved in forex market.

Currency hedging is a technique which reduces the risk involved any foreign exchange transaction. There are several options available in the market that provides currency hedging service up to various extent. First is forward contract, as per this service a person can lock the rate at which they will sell or buy currency on any date in the future. The agreement is done between the forex company and that person. The rate fixed by the dealer and an individual is widely known as forward exchange rate or forward rate. Forward exchange rates provide 100% currency hedging. As per forward contract service, a person can execute the order within the specified period which can be 1 month, 6 month or a year. The time span to execute payment is predefined between the dealer and an individual while making the agreement.

Another service which offers currency hedging is sport contract. However, sport contracts do not offer 100% currency hedging. A spot agreement means sale and purchase of foreign currency in a very small duration and with the current applicable rate. Forward exchange rates are spot rates of future. To trade with the spot rates, a person needs to analyze the currency fluctuation in market well in advance. Based on his research, a person can predict one rate and execute transaction in a very short duration. However, it may happen that sudden changes occur in the currency rates which can destroy the currency hedging service for your transaction and can put you in loss. It seems that because of the inadequate terms applicable in spot rates, traders are more attracted towards forward exchange rates.

There is one more reason why traders prefer forward exchange rates over spot rates is the time given for execution of payment. In property business, it is not possible to execute payment within 2 days of span.  Forward contract service is widely used by the corporate people who are involved in forex market.