Getting familiar with FX: Forward contracts
We live in an incredibly volatile world. A reality TV show host governs America, every Brexit headline sparks movement in GBP, and flash crashes are increasingly frequent. If you’re an internationally trading business shipping products across the globe, a sudden development in the exchange rates can cost thousands.
Accordingly, wise multinational corporations are taking steps to protect themselves from market variance. In this post, we’ll talk about forward contracts, and how you can use them as a hedging tool.
Great exchange rates: here today, gone tomorrow
See a favourable exchange rate? Jump on it while you can – a headline is all it takes for it to vanish. You could wait until you absolutely need to make a transfer in order to make oner. However, even waiting a few days means you’re wagering that exchange rates will remain in your favour. If it moves against you, too bad, so sad.
Don’t wait any longer than necessary to make an international payment (or receive one from abroad). Let’s say you’re shipping export to Singapore, from the UK. Buying it domestically in Singapore Dollars and being paid in British Pounds. In a few short months, you think to yourself, Brexit will be settled, one way or another, so you’ll wait until then to get paid in the UK.
You expect it will fail, sending SGD sharply higher against the GBP. With a current exchange rate of 0.558, you’re anticipating a rise to 0.590 or higher. The day comes, and to your bewilderment, a new motion overturning the results of the poll’s decision on brexit, passes the Parliament. The GBP soars, dropping SGD/GBP rate to 0.525.
These differences will make up to 10% difference in the net amount of cash you will have in pocket. It bears repeating – expecting great exchange rates to stick around is a dangerous gamble nowadays.
Shifting exchange rates can cost you deals
International commerce has made the world wealthier than ever. By shipping your product overseas, or by expanding globally by opening overseas offices, you can magnify the success of your business. We could even say it’s a necessity nowadays.
However, recent Forex market volatility has introduced risks which need to be put into consideration in addition to many other variable factors that you have to consider. Let’s assume you’ve just come back to the USA from Mexico. While there, you found a beautiful lot for sale on the Gulf of Mexico outside Merida.
You plan on snagging it and shipping it back to the USA for a nice profit margin, but with exchange rates already at 18:1 (USD/MXN), you think rates may decline further. So, you decide to wait a few months to complete the deal. In that time, the trade war weakens the USD and crime decreases in the Yucatan, strengthening USD/MXN to 15:1. Now, you don’t have enough USD on hand to cover the down payment and closing costs. A few weeks later, someone else snaps up the parcel you were going to buy. Sad.
Set it and forget it: how forward contracts can put your mind at ease
Shifting exchange rates while shipping products for import or export purposes can cost you money.. Fortunately, the financial industry has come up with products to mitigate this risk. The forward contract is among them, as it protects buyers and sellers from fluctuating commodity prices.
How do they work? Here’s an example – a farmer in Iowa, USA wants to buy feed from a supplier in Alberta, Canada. The exchange rate, which has hung in the 1.250 to 1.300 range for much of 2018, makes it cheaper than domestic brands.
However, if the price of oil climbs in 2019, the farmer may end up locked into an expensive contract. To seal the deal, both parties agree on a forward contract with a USD/CAD exchange rate of 1.275. This way, the farmer gets a cheap deal, and the supplier secures a decent profit.
The same logic applies for the exporter who is shipping the product. Shipping by sea can take weeks and months, and in the meanwhile the exchange rate can vary tremendously. Fixing the exchange rate via a Forward Contract can eliminate this unnecessary and risky rate rattling, and make the exporter who is shipping the product know precisely how much will he get paid upon delivery.
Banks make it hard for everyday people/SMEs to get forward contracts
As beneficial as forward contracts are for buyers and sellers, they can be hard to find. Many banks don’t offer them, and when they do, minimum limits price out most small businesses and individuals.
For example, customers of HSBC in Hong Kong have to send at least $5,000 to use a forward contract. This lofty limit makes it difficult for SMEs and impossible for remittance senders to take advantage.
However, most retail banks, even the largest ones, don’t offer this progressive hedging tool. Revenue streams from currency exchange are small – there is no incentive for them to provide services like forward contracts.
Money transfer providers offer easy access to forward contracts
On the other hand, currency exchange is the main product of currency transfer services. To distinguish themselves from banks and other competitors, some companies offer forward contracts.The seas of international commerce are stormy – by offering their customers forward contracts, they get badly-needed cost certainty.
Better yet, money transfer providers offer lower minimum transfer limits for forward contracts. Firms like TorFX have low minimums ($150), making it easy for folks like remittance senders and small business owners to use them.
Don’t let Forex market movements ruin your day
All it takes is one jobs report, vote, or flash crash to cost you a fortune. Don’t assume currency exchange rates will stay the same – lock in a stable rate using a forward contract. When it comes to your money, it’s better to be safe than sorry.
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