Types of Forward Contract
20-10-2022 | Harry Mills | treasuryXL | LinkedIn
A forward contract is an agreement to buy or sell one currency for another at an agreed rate and at an agreed future date. Forwards are traded over the counter, meaning they are not traded on a central exchange; instead, they are privately negotiated, legally binding agreements between two parties, typically a bank or broker and its client.
By Harry Mills
For businesses, forward contracts provide a mechanism to secure exchange rates for future exposures and minimise the impact of currency fluctuations and market volatility. Forwards are favoured by treasurers and FDs/CFOs for their simplicity, availability, flexibility, and certainty they provide.
The exchange rate on a Forward is typically higher or lower than the spot rate – this is due to the interest rate differential of the two currencies involved. Read more in my blog post on forward pricing for more information!
The Benefits of Forward Contracts
The decision to hedge or not is unique to each business and its situation. If currency hedging is appropriate and would help a business to reduce risk and achieve its objectives, then forward contracts will likely play an important role in the strategy:
- Certainty – Guarantee the exchange rate for future payments or receipts
- Predictability – Securing future conversion rates makes cash flows predictable
- Flexibility – Some contracts can be used at any time before the maturity date
- Simplicity – Trade quickly online, in any size, and in most currencies
Types of Forward Contract
The basics apply to all contracts – a set amount, rate, and future maturity date, but there are three main types of forward contracts to be aware of:
- Fixed: Settlement is restricted to one future date only
- Open: Fully flexible, allowing settlement at any time up to the maturity date
- Window: Can be utilised within a window of time up to the maturity date
The open forward gives the most flexibility for drawdowns and utilisation, but it can come at a price: The reason that three types of contract are available is that the forward rate is influenced heavily by the length of the contract and the size and sign (positive or negative) of the interest rate differential of the two currencies involved. There could be a benefit to a business in selecting a fixed or window forward contract, rather than a fully flexible, open contract.
A quick example:
- An Irish company imports from China in USD (so they sell EUR to buy USD)
- They have an invoice of $500K to pay in 6 months’ time
- The spot rate is EUR/USD 1.0000, and the 6m swap points are +0.0120
- Open Forward exchange rate is quoted at 1.0000, $500K costs €500,000
- Fixed Forward exchange rate is quoted at 1.0120, $500K costs €494,071
If in doubt, you should speak to your FX provider about forward pricing and which solution would be best for your needs, balancing flexibility and market pricing.
What to look for from your FX provider
Your currency provider should provide you with clear and consistent pricing for forward contracts. They should give you transparent and honest guidance as to the pros and cons of each contract type, and allow you transact how you want, whether that’s over the phone or online.
It’s common for FX brokers to overcharge or “keep” forward points to increase spreads (their margins), so ask for a fixed pricing schedule which includes transparency on forward points.
Forward with Oku Markets
Oku Markets provides live forward contract trading to clients online and via our telephone dealing desk. We always give our customers fixed, consistent, fair, and transparent FX prices, so you can trust us to work with you, not against you!
Contact us at @[email protected] or 0203 838 0250 to discuss your needs!
Here’s a quick video of our online platform showing the few clicks to trade:
Thanks for reading 👋
Harry Mills
Founder at Oku Markets
Managing Business FX Risk
