Forward Contract: A Risk Management Tool Everyone Must Know

Forward contracts can be a great tool for reducing risks on making a variety of deals. Businesses and individuals can use them in a variety of situations, such as purchasing property abroad, working with overseas suppliers, or completing various deals. This tool is most often used for hedging or speculating in foreign currency exchange and trading.

What Exactly Is a Forward Contract and How Does It Work?

A forward contract is a contract in which two parties agree to sell/purchase an asset at a specific price they agree on now, but the purchase itself will be completed in the future. When applied to foreign currency exchange deals, it’s a contract that allows you to secure a specific rate for a certain period of time. The latter can go up to a year, depending on who offers the contract.

In many ways, forward and futures contracts are very similar, but they differ in some technical details. The most important difference you need to understand is that you pay the price of the forward contract when you sign it, but the actual settlement (sale of the asset) happens at the end of the contract. Whereas with a futures contract, you settle a small part every day.

An expert dealing with finances should have no trouble understanding what a forward contract is and how to use it to their advantage. However, if you don’t have a background in finance, it’s imperative that you study a variety of resources that get a Forward Contract explained in layman’s terms. Various information portals related to the international money transfer industry can be a great help in this case because forward contracts are one of the key tools used by money transfer companies.

These businesses definitely aren’t the only ones offering forward contracts for FX deals. However, getting one from a bank is extremely difficult even for big businesses, and this service might be completely unavailable to individual clients.

Money transfer companies, on the other hand, offer forward contracts freely, which helps them boost their business and helps their customers protect their interests when transferring funds overseas.

Benefits of Forward Contracts for Businesses and Individuals

First and foremost, forward contracts are a risk management tool, which means that their most important benefit is eliminating the risks. When applied to foreign currency exchange, they help you avoid potential losses caused by the fluctuations in exchange rates for deals that need to be paid for in the future.

For example, you need to make a payment to a supplier abroad, but you are only starting your negotiations. This means that you’ll be making the actual payment weeks or even months from now on. During this time, currency exchange rates might change, thus making the deal go outside your budget.

Obtaining a forward contract at the moment you start negotiations, the same moment you calculate your budget for the deal with the current rates, will ensure you avoid this kind of pitfall. That’s risk elimination in action.

However, currency fluctuations can go the other way round as well. This means that you might be the one losing a chance to make a payment at a more favorable rate thus saving your company money. That’s a risk inherent to all hedging tools and it depends on you to minimize it.

This matter is especially important for FX traders, for whom forward contracts are one of the best hedging tools. Even with the changes in some regulations that make it harder to hedge on foreign currency exchange deals today, forward contracts remain popular due to their efficiency at the hands of experienced traders.

The key to reducing the risk of losing on your own forward contract is researching past rates along with current situations in both countries. Major events within the state always have an impact on the strength of its currency, so if there are any political or economic upheavals on the horizon, you can expect the currency to weaken. This might happen extremely fast leading to either losses or gains on your part.

Studying the dynamics of the particular currency pair can help you make some predictions and understand whether you need a forward contract at all. However, you need to understand that this contract in itself is not a prediction tool.

Price of a Forward Contract Explained

The price of a forward contract is calculated using a rather simple formula with three deciding factors:

  • Current spot rate
  • Interest rate differentials between the two currencies in question
  • Time

When using forward contracts offered by money transfer companies, you should expect to pay about 10% of the total value at the beginning. The rest will need to be paid when the contract ends.

Money transfer companies made a great change by bringing forward contracts to everyone willing to use them. This is making a huge difference for businesses and individuals using their services to transfer money abroad. In particular, this tool is popular among individuals investing in real estate abroad.

This industry has been growing rapidly with the help of globalization. The same happens with multiple other avenues for investment as governments of the world realize the opportunities this offers for their countries and they change legislation to make foreign investment easier.

As money transfer companies made international payments much more affordable, more people today enter the international investment market because today one doesn’t need to have a huge fortune to do it.

The availability of forward contracts has, no doubt, been a major factor in this development. When used wisely, this hedging tool can help businesses and individuals increase their fortune and profits in various ways.

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