Guest post by Manuel Lopez, CTP, Regional Director of Sales, Southeast, at Cambridge FX
The unpredictable movement of exchange rates in foreign currency markets can have a lasting impact on your bottom line. As an international business, you understand the practicality of making payments to your foreign vendors in their own currency, depending on the current rate.
Foreign currency markets can be all over the place, especially during unpredictable events (such as a global pandemic). These fluctuating markets can make it difficult for importers and exporters to plan and forecast their foreign currency exposures. Luckily, there are tools available to help mitigate these risks and bring more certainty to your business’ financial planning.
Forward contracts can help
Here, we will focus on to leverage a forward contract to hedge currency exposures. This brings some certainty to your foreign exchange costs, helping you budget and plan with confidence. We will also discuss some of the pros and cons of utilizing a forward contract as a possible hedging tool.
We are all familiar with a spot foreign exchange transaction, where you sell one currency for another currency at a spot market rate. This rate can significantly fluctuate, and there is a period of potential risk if you commit to an invoice payment payable in another currency 30 days later.
An alternative is a forward contract, which is an agreement to exchange one currency for another at a predetermined rate for an agreed time in the future, known as the “maturity date.” After booking a forward contract, companies can accurately predict what their future cash flow will be for a particular expense or invoice.
Currency forwards are booked for the exact amount of an invoice or expense, allowing you to fully hedge any exposures you may have. There are various features with some forward contracts: they can be booked as closed, open, or with a window period. Closed forwards must be settled or paid at maturity, while open forwards allow the flexibility to access or drawdown from the contract at any time throughout the life of the contract. Window forwards allow you to drawdown within a specific timeframe–or window–and can be at any point between the transaction date and the maturity date.
Deciding which type of forward contract to execute depends on your specific exposures and payment terms, including any discounts you may realize for early payments.
Advantages of using forward contracts
One of the advantages of a forward contract is certainty over the exchange rate irrespective of the prevailing spot market rate at time of payment. Forward contracts also help businesses to protect their profit margins from foreign currency appreciation or unfavorable market moves.
Disadvantages of using forward contracts
One of the disadvantages of foreign currency forward contracts is that if the market moves in your favor, you are obligated to execute at the agreed upon rate and not take advantage of the favorable market move. However, the purpose of the instrument is to bring more certainty to your future cash flows, and forward contracts can help to do that effectively.
Companies should not measure the success of a hedge based on where the spot rate is trading relative to the forward contract rate. The success of a currency hedge should be measured by if the objectives of the hedge have been met.
There are other currency tools available to hedge your currency exposures aside from forwards contracts. Knowing your specific exposures, objectives, and budgeted rate of exchange helps you determine which product is best suited for your unique needs or requirements.
To learn more about forward contracts or the different tools available to hedge your currency exposures, please contact me at firstname.lastname@example.org.