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Forward contracts



 

 

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.

 Shortcomings:

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.

Please click on the links below for more hedging techniques