What You Need to Know About Forward Contracts

Small business owners who work with partners abroad need to budget carefully in order to save their money and create a profit margin. Choosing when to convert currency can be a tricky matter, as market fluctuations will have a big impact on exchange rates.

Luckily, securing a stable exchange rate for your business can be a relatively straightforward matter — thanks to forward contracts. Forward contracts will help you budget for the exact amount of foreign currency that you are able to buy or sell, removing the risk associated with sudden market shifts.

What is a forward contract?

Also loosely referred to as a “futures contract” and “fx forward,” forward contracts are agreements between two parties to sell and buy a certain amount of currency within a given time frame. This effectively sets the price in stone so that the buyer can anticipate costs and calculate profit margins for international transactions.

But why do sellers offer forward contracts? What are their incentives? Forward rate agreements guarantee business for the seller, as well as a stable price for the buyer. A forward contract lets the seller know how much currency will be needed. That’s called “hedging risk,” which just means that the contract offers a degree of protection against fluctuating exchange rates in the future.

Forward financing also gives people time to buy more of a particular currency with a narrow cash flow in the present. If you know cash is coming, but you want to take advantage of the current rates, then a forward contract is the answer!

How to benefit from a forward exchange contract

Benefits from forward contracts exist whenever there is any risk of currency fluctuation.  The key to using these contracts effectively is having an accurate projection of the amount of currency needed and the time frame within which it will be needed.  The greater the degree of accuracy in projecting these two variables, the higher the financial benefit of using a forward contract.

Are there pitfalls with forward contracts?

Forward rates are fixed by definition, so this really comes down to finding a transparent and trustworthy company to honour your forward contracts. The beauty of forward contracts is that they are win-win agreements between people who know they will need the foreign currency and sellers who have stocked up on that currency to accommodate the needs of businesses and travellers. The exchange rate is set between the buyer and seller, so there are no surprises—just peace of mind.  That being said, the entrepreneur who enjoys the rush of “winning” in the currency game will find the safety of a forward contract less exciting.  While avoiding loss is an advantage, there’s also no chance of gain.

A forward contract example in action

Let’s look at how the theory plays out in real life: a small business owner who imports and sells goods from foreign markets needs to pay for her stock in each country’s local currency. Canadian dollars aren’t accepted, and—contrary to popular opinion—neither are American dollars. From there, it’s a question of securing the best rate.

Like any effective business owner, she looked at her costs and calculated the profit that she needed to hit. This made her situation a question of how to reach that profit, rather than “if” she would reach it — and the currency exchange rate was the biggest X factor.

Playing it by ear would leave profit margins open to fluctuations from external factors, so our business owner arranged a forward contract to purchase the foreign currency she would need each month to keep her business operating. From there, she was able to calculate her projected profit margin with a high degree of certainty.

You can bring the same level of stability to your business by planning in advance! Contact us at Currency Converters to explore the best possible forward contracts.