How do forward contracts work?

How do forward contracts work?

Firstly, let's establish what a forward contract is: A forward contract is an agreement to exchange one currency for another on a specified date, typically within the next 12 months, at a predetermined price known as the forward rate.

The forward rate is the exchange rate agreed upon today for a currency transfer at a future date. It is usually derived from the current spot rate and adjusted based on factors like the time until the transfer and the currencies involved. It's crucial to note that the forward rate agreed upon today may vary from the rate on the day of the actual exchange, hence why it's called a forward contract.

Example of a forward contract

John, the owner of ABC Ltd, a UK-based manufacturing company, purchases approximately $1 million worth of materials from China each year. Due to market uncertainty and significant fluctuations between GBP and USD in the past year, John decides to secure a fixed exchange rate for $1 million to cover his supplier costs over the next 12 months. This allows him to lock in the exchange rate and mitigate the risk of currency fluctuations during this period.

With this forward contract, John gains the flexibility to either take the full $1 million contract at the agreed-upon date 12 months in the future or withdraw portions of the contract (more details on this below) as needed to make payments to his suppliers.

Are there variants of a forward contract?

Yes, there are multiple variants of a forward contract, so it's important to understand how each one works to make an informed decision about which one best suits your needs. Let's explore the common variants:

• Fixed Dated forward contract - A fixed-date forward contract restricts the owner from accessing the contract before or after the agreed-upon settlement date. This type of contract is suitable when you have a set and non-negotiable settlement date and anticipate making a single lump-sum payment.
• Open window forward contract - A flexible forward contract allows the owner to use the contract in full or in multiple parts within the agreed contract period. This variant is ideal if you need to make multiple payments within the contract limit or if your end date is uncertain.
• Fixed Window forward contract - A window forward contract allows you to use part or all of your contract within a specific period. For example, if you have a 12-month contract with a usage window between months 3 and 6, you can opt to use part or all of the contract during that time frame. This is useful if you have an estimated payment date that isn't set in stone.
• Long Dated forward contract - Long-dated forwards are forward contracts that extend beyond the standard 12-month window, often with maturity dates of up to 10 years. These are ideal for large projects that span multiple years.

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What is a drawdown on a forward contract?

A drawdown on a forward contract allows you to access and use part (or all) of your contract before the originally agreed maturity date. For example, ABC Ltd purchases a 12-month forward contract for $1 million on February 1, 2024, with a maturity date of February 1, 2025. If ABC Ltd needs to make a payment of $250,000 three months into the contract on May 1, 2024, they can draw down $250,000 from the original $1 million and settle the payment in GBP based on the forward contract exchange rate. After this payment, the forward contract will have $750,000 remaining.

What is a rollover of a forward contract?

A rollover of a forward contract involves extending the maturity date of the contract to a new agreed-upon date. It's important to note that not all providers permit rollovers, so if you anticipate needing to extend your forward contract, it's crucial to contact your provider to understand your options.

Do I need to make a down payment for a forward contract?

It is common to make a down payment, often referred to as a deposit, against your forward contract. This down payment is then deducted at the end of the contract. Down payments typically range from 5-10% of the contract's value, although some providers may allow you to secure forward contracts with no down payment. A down payment serves as security and potential collateral for the liquidity provider from whom the forward contract is purchased, safeguarding against non-settlement. Additionally, a down payment aims to protect you from potential margin calls (explained below) in the event of adverse movements between the currency pair in your contract.

What is a margin call?

If, at any point during your forward contract, the market moves beyond the value of your initial down payment, you will be required to provide additional collateral, known as a margin call. This additional collateral will be held in addition to your original down payment and will be deducted at the contract's completion.

For example, if ABC Ltd purchases a 12-month forward contract for GBP to USD with a 5% down payment, and six months into the contract the GBP/USD exchange rate fluctuates adversely by 10%, ABC Ltd will be margin called for an additional 5% of the contract's value. It's important to note that multiple margin calls can occur during the duration of your forward contract. Once a margin call is requested, you typically have 48 working hours to provide the additional funds.

When entering into a forward contract, it's essential to fully understand the potential implications and obligations in the event of adverse currency market movements. Some providers may offer 0% deposit forward contracts but include small print stating that you will be margin called at certain levels of adverse movement, while others may offer 0% deposit contracts with no margin calls at any point. The more typical 5-10% deposit is designed to minimize the likelihood of a margin call, as it is uncommon for a currency pair to fluctuate by 5-10% within 12 months. However, such fluctuations are not impossible and should be considered.

What happens if I don't pay the margin call on a forward contract?

If the margin call isn't paid within the requested timeframe, your provider has the right to cancel and close out the forward contract. Any resulting financial loss will be deducted from your initial down payment/deposit. If the loss exceeds the down payment, you will be responsible for covering the additional amount.

What are the pros of a forward contract?

• Excellent for minimizing your exposure to currency fluctuations
• By purchasing a forward contract, you lock in your exchange rate, ensuring you know exactly how much you need to pay.
• Helpful for businesses that need to budget efficiently and plan ahead.
• Simple and efficient to execute and manage.

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What are the cons of a forward contract?

When you purchase a forward contract, you commit to buying at the agreed exchange rate. If exchange rates move in your favor during the contract's duration, you are locked into a lower rate than the current market rate.

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Interested in purchasing a forward contract or uncertain about whether it's the right choice for you? Contact our expert team at Apex Currency to discuss your options and determine the best solution for your needs.

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