Confidence on exchange rates

Are you due to receive a sum in foreign currency in a few weeks or months? Or do you need to settle an invoice in a few weeks or months in a foreign currency? A  forward contract gives you confidence on the exchange rate. A forward contract is nothing more than agreeing to buy or sell a certain amount of foreign currency at a given date in the future. With a forward  contract, you fix the exchange rate of an amount in foreign currency. And that means you know in advance how much you will pay or receive. 

How does it work?

Suppose you agree with your supplier that you will pay dollars in three months time. Using a currency future you do not have to worry about what the exchange rates will be doing then. Even if the dollar increases in relative value, you can be confident that you won't have to pay any more euros to your supplier. After all, you have hedged the risk of the dollar rising.

You can use the same principle if you are expecting payment from a foreign customer. The rate at which you exchange the amount received is fixed using a futures contract. And that means you know exactly how many euros you will get, so you won't receive a lower amount than you thought.

Pro's and cons

Pro's

  • You know in advance exactly how much you will be paying or receiving in euros
  • You are insured against negative FX-rate fluctuations
  • Cheap solution, as there's no premium

Cons

  • You don't benefit from positive FX-rate developments
  • A currency future is a liability. If a deal falls through you are still liable to buy or sell foreign currency. This system is therefore not suitable if you are still in the quotation stage.

 

Example

Paying your Chinese supplier in three months

Suppose that in three months time you have to settle an invoice to a Chinese supplier of $ 100,000 and the EUR/USD is at $ 1.10. You expect the dollar to rise over the next three months. So you take out a currency future. This means you already know which amount you will have to pay in euros. The price at which you can buy dollars in three months with a currency contract (the forward rate) is $ 1.1055. 

The situation after three months

The euro has fallen in value to $ 1.08. So the dollar has become more expensive to buy. Thanks to the currency future, you pay less. Instead of € 92,592.50 (100.000/1.08) you pay €90,456.80 (100.000/1.1055). The currency future has saved you € 2135.