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What is a forward contract?
Lock in a strong exchange rate for future international money transfers.
When you need to send money overseas, the exchange rate determines the cost of the transfer. Protect yourself against fluctuating exchange rates with a forward contract — but you risk missing out on a favorable exchange.
What are forward contracts?
A forward contract is an agreement to buy an asset at a set price at a later date. When you’re making international money transfers, securing a rate in advance allows you to plan ahead and safeguard your finances against any potential drops in the value of the dollar. If you watch the market and current events, and expect the currency you plan to send to fall, placing a forward contract can limit your exchange risk and get you a better value.
How do forward contracts work?
When you place a forward contract, you have 12 months to make the transfer at the locked-in rate. To calculate the rate for your forward contract, a money transfer provider adjusts the spot rate — the current market exchange rate — for what are known as “forward points.” Forward points factor in the difference between the interest rates of the sending and receiving countries, and considers the length of time until your transfer is set to be completed.
You usually need to pay a deposit to secure your exchange rate, but are protected against any possibile exchange rate fluctuations until your transfer.
Case study: Brian sends money back home
Brian knows he needs to send a transfer of $5,000 to Australia in two months to pay his brother an outstanding debt. The current exchange rate is 1 AUD = 0.70 USD, but financial experts and economists are predicting the value of the Aussie dollar to rise in the coming weeks. Brian doesn’t have all the funds to transfer the full amount now, so he places a forward contract with an online money transfer provider and locks in the current exchange rate.
He pays a 10% deposit of $500 and, and two months later pays the remaining $4,500 to complete his transfer. Brian’s brother receives AUD $7,142.86 two days later.
Had Brian not placed a forward contract and simply transferred the money using the best exchange rate he could find, he would have had to settle for an exchange rate of 1 AUD = 0.73 USD. This means his brother would only have received AUD $6,849.32 — almost $300 less than he received thanks to Brian’s forward thinking.
Forward contracts vs. futures contracts
Futures and forward contracts are both agreements to exchange money or a product at a set rate on a future date. The difference is that forwards are private agreements, while futures are publicly traded agreements.
You make a forward contract directly with the money transfer service or party you’re trading with. Once you create your agreement, it doesn’t change, and your money is delivered at the time you agreed on.
Futures contracts, on the other hand, are traded on futures exchanges. You’re trading with someone on the market, and the contract ensures that the trade meets all standards and is completed properly. So, there’s less counterparty risk, or risk of someone defaulting, than with forward contracts. Futures can be traded back to the market if you change your mind or the market moves against the direction you thought it would go.
How do I compare forward contracts?
- Exchange rates. Although forward points are calculated using an industry standard formula, the spot exchange rate differs from one company to the next. Find a transfer company that offer the best exchange rates.
- Fees. Find out if you need to pay an extra fee to lock in a forward contract, and if there are other fees the company charges.
- Transfer options. Consider the options available for placing a forward contract, such as online, over the phone or by using a mobile app.
- Customer support. Find out how to contact customer support if you have questions about your transfer.
What are the benefits of a forward contract?
The main benefit of forward contracts is that they protect you from risk when making an international money transfer. Other benefits are:
- Potential to save money. 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 the transfer occurs, 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 the best exchange rate you can find.
What are the risks of forward contracts?
The biggest risk of a forward contract is that the exchange rate could go against you. Predicting the future value of a currency can be difficult, so there’s a risk the exchange rate will change in the interim and cost you money. A huge range of factors can affect the value of one currency relative to another, and sometimes it’s not possible to predict exactly which way the value of a currency will go.
Compare platforms to trade forex
Forward contracts can let you lock in an exchange rate for a future international money transfer and protect your money from unexpected fluctuations. If you’re looking to actively trade currencies rather than send money internationally, consider a forex trading platform with better tools for more advanced foreign exchange.
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