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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.
Compare providers that can help you set up forward contracts
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?
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.
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. An introduction to forex futures
Frequently asked questions
Yes, many do. Check with your money transfer service, and consider using a forward contract if you’re moving large amounts of money.
Check the mid-market rate between the two currencies you’re trading. The mid-market rate is what your money’s actually worth on the global market compared to another currency. It’s the midpoint between worldwide supply and demand for that currency — and the rate banks and transfer services use when they trade among themselves.
Use the mid-market rate as a baseline to compare against the rates provided by your bank or transfer service.
Compare multiple money transfer providers. You may find a good rate at one provider but later find an even better rate elsewhere. We’ve done the hard work for you and compared the top money transfer providers so that you can find the best rates.
Kelly Waggoner is editor-in-chief of Finder US. 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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