Exchange rates move constantly. Forward contracts give your business the freedom and flexibility to take the unpredictability out of currency conversion and budget effectively to protect your profit margins from negative market movements. This means no more worrying about exchange rate volatility.
Regardless of which direction the market moves you will know the exact cost of the foreign currency amount you need when you are ready to make a transfer. The best part: you don’t have to pay anything until the currency is actually needed, keeping that cash free for other uses; in other words, planning and budgeting just got a little more stress-free.
Forward contracts are especially useful for businesses that forecast payables into the future. If a payment is coming in 90 days from now, there can be a lot of fluctuation in the currency market between now and then. But by locking in a rate today, you can plan for profits while protecting against market volatility.
How It Works?
Forward contracts are probably the most popular and efficient hedging tool. It allows profits to be protected from unfavorable market moves and allows you to lock in today’s spot exchange rate for a specified amount of currency at a future time.
For example, if today’s Euro/US Dollar forward rate is 1.19 and you have an invoice or a project that requires payment of €100,000 in 60 days, you can lock in a forward for delivery in 60 days for a cost of USD $119,000.
You lock in the rate now and pay the full amount 60 days later. This protects the invoiced amount from any change in the Euro cost when it comes time to pay and frees your current cash balances because you pay for the forward in 60 days, not when you agree to buy it. If you did nothing and the USD/Euro rate increases to 1.30 in 60 days, your cost is USD $130,000, an increase of $11,000. Forwards solve this problem and ensure that foreign currency costs are consistent with your budget. This way you easily avoid the 5% to 15% price increase your foreign suppliers add to their U.S. dollar prices, and you also protect your budget against exchange-rate volatility.
The only risk you have after buying a forward is the opportunity cost of the dollar increasing in value. For instance, if the dollar increases in value against the Euro (say 1.16 in the Euro example or USD $116,000) and you did not buy a forward contract, you would have been better off waiting. However, buying a forward eliminates the risk of an unknown future. In the end it depends on your company’s tolerance for risk.
Since none of us have a crystal ball to accurately predict the future, guessing the future currency rates is a gamble that is best avoided. A forward purchasing policy gives a company structured guidelines to follow when protecting its budget continuously over time. So, the projected budgeted profits are constantly protected. That why It’s important to stress that often doing nothing is more risky than hedging your risk with a forward.
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