What is a forward contract — and how can it help your business?

What is a forward contract?

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If your business makes frequent transactions with foreign currencies, a forward contract could be a helpful tool to protect your transactions against market fluctuations.

What is a forward contract?

A forward contract is a “hedging” tool that doesn’t require upfront payment. When two parties sign a forward contract, they agree to trade a certain amount of one currency for another currency at a later date. At the same time, they set the exchange rate for the future trade.

Why is a forward contract useful?

The main reason you would use a forward contract is to limit your risk. Exchange rates change day to day, and they can spike or drop on a dime. It’s especially tough to predict what exchange rates will be a long time from now. To protect yourself, a forward contract essentially locks in the exchange rate that you’ll receive in the future.

Forward contracts: An example

Let’s say you’re an exporter in the United States selling factory equipment. You sell 10 pieces of equipment to an importer in France, stipulating that the importer will pay you in five months.

When the importer pays you, he’ll send the funds in euros, so you’ll need to convert them to dollars.

You know today’s exchange rate between dollars and euros. But if the importer pays you in five months, who knows what the exchange rate will be at that time.

For this reason, you sign a forward contract. This lets you lock in the exchange rate you’ll get for trading euros into dollars five months from now.

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Are there any drawbacks?

Even though a forward contract can protect you if a currency depreciates, you give up what you’d gain if the currency appreciates. Many people find that’s not a huge deal — you’re not losing money. But it can sting when you lose out on a big exchange rate swing in your favor.

What are the pros and cons of forward contracts?

Pros

  • Protect yourself. Forward contracts allow you to protect your finances against the impact of fluctuating exchange rates.
  • Buy now, pay later. You don’t have to pay for the full cost of your transfer until it is actually placed, which could be up to 12 months into the future.
  • Choose a rate that suits you. Forward contracts give you the power and freedom to secure an exchange rate that suits your financial needs.

Cons

  • The exchange rate could improve. Predicting the future value of a currency can be difficult, so there is a risk that the exchange rate will rise in the interim and cost you money.

What else should I know?

A forward contract is binding — even when one party will lose a lot on it.

You can also create a forward contract with your bank. The bank will offer you a forward rate that’s slightly less than the current exchange rate.
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Kelly Waggoner

Kelly Waggoner is a senior editor with finder.com. She's worked with publishers, magazines and nonprofits throughout New York City, including ghostwriting a how-to on copyediting for the Dummies series. Between projects, she toys with words, flips through style guides and fantasizes about the serial comma's world domination.

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