Forward contracts enable to avoid adverse impacts of currency fluctuations.Indeed Importers and exporters who are engaged in transactions denominated in foreign currency can benefit from using this hedging tool.
A forward contract is a firm engagement to deliver a certain amount of foreign currency at a given date and at a fixed exchange rate.
Let’s take the example of Spanish Importer who concluded a 10 565 240 USD (10 M EUR) deal with a US Exporter with a 90-day payment term. Note that at the time of the agreement, the exchange rate was 1 EUR = 1.0565 USD. In order to avoid the risk engendered by a potential rise of the USD, the importer will ask his Bank for a 3month forward exchange rate.
The Banker will proceed as follows:
He will borrow 10 M EUR with a 1% interest rate during 3 months.
He will then buy USD and invest them for 1.5% yield during three months.
Based on the preceding the banker will offer a 3 month rate of: 1 EUR=1.0578 USD
1.0565 * (1+90/360* 0.015) / (1+90/360*0.01) = 1.0578
In this case the fact that the 3 months forward exchange rate is higher than the spot rate is explained by the better yield in USA.
Therefore, by entering into a foreign contract, the Bank will have the obligation to deliver 10 565 240 USD against 9 987 937 EUR (10565240/1.0578) at maturity.
Unlike option contracts, forward contracts does not allow to benefit from favourable fluctuations since the Banker and the Exporter have the obligation to deliver a specific amount of foreign currency at a specific exchange rate and at a specific date.
As a result forward contracts are usually cheaper than Options, which means that, depending on circumstances, a trade off between flexibility and price will have to be made.