What is a forward contract?
Last updated: 27.12.2024
Discover how you can fix exchange rates with forward contracts and protect your profit margins
Key takeaways
- Forward contracts let you lock in exchange rates for a specific period of time, protecting your business from unpredictable currency fluctuations
- Fixed exchange rates through forward contracts offer a competitive advantage by enabling consistent, stable pricing
- WorldFirst offers forward contracts with up to 24 months of fixed rates, helping businesses manage international payments efficiently
Introduction
For businesses that make frequent international payments, sudden currency fluctuations can affect operating profits and lead to loss of revenue. While you can’t control the currency markets and the sudden fluctuations in exchange rates, you can take measures to protect your profit margins.
One way to manage foreign exchange risks is by booking a forward contract and fixing an exchange rate for subsequent international transfers. Keep reading to learn how forward contracts work and why your business should consider using them.
Table of Contents
Understanding forward contracts
A forward contract is an agreement where your payment provider guarantees a specific exchange rate for international transactions for a predetermined period of time.
International traders can use forward contracts to reduce uncertainty due to currency fluctuations, stabilise business cash flow and enable better financial management.
The forward rate is agreed upon in advance when the contract is made. It can be determined by several factors like the current exchange rate of the currency pair and the total time of the contract.
How do forward contracts work?
Here’s how a forward contract agreement works:
- You get in touch with a bank or payment provider that supports forward contracts
- They’ll review your requirements, transaction volume and the current spot rate to offer the best possible exchange rate for the forward contract
- You enter the forward rate contract and start making international payments at a fixed exchange rate, adding more predictability to international trades
However, remember that no matter what direction the exchange rates move in, you will only get the originally agreed exchange rate. One downside of forward contracts is missing out on potential gains if exchange rates become favourable. Though, for most customers, the certainty and stability of exchange rates outweigh the downsides of forward contracts.
What are the key components of a forward contract?
There are four key components of every forward contract, which include:
Currency pair: The two currencies that will be exchanged for example USD/AUD or CNH/AUD
Contracted exchange rate: The fixed exchange rate at which the currencies will be exchange until the end of the forward contract
Contract period: The period of time until the contract will stay valid
Terms and conditions: Any conditions, clauses, or specific requirements for settlements. The payment provider usually shares the terms and conditions in advance
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- Save with competitive exchange rates on currency conversions and transfers
- Lock in exchange rates for up to 24 months for cash flow certainty
Forward contract vs firm orders vs spot contracts
If you make frequent international transfers, it’s necessary to understand the difference between forward contracts, firm orders and spot contracts.
| Forward contracts | Spot contracts | Firm orders | |
|---|---|---|---|
| Purpose | Lock in an exchange rate for future transactions | Immediate international payments at the current market rate | Target a specific exchange rate for a future transaction |
| Exchange Rate | Fixed, agreed upon in advance | Based on the live market rate (spot rate) | Executed when the market hits your desired rate |
| Time Sensitivity | For future transactions over a set period | Immediate or near-immediate transactions | Monitors market 24/7 and executes when target rate is reached |
| Certainty | Provides predictability and stability in exchange rates | The exchange rate is determined at the time of transaction | Provides the desired rate if the market hits the target, but no guarantee |
| Flexibility | Limited; fixed rate regardless of market fluctuations | High; rate is based on current market conditions | Medium; flexible to market changes but limited to target rate |
| Process | Requires agreement with a bank or payment provider | Simple, quick transaction with rate based on current market | Requires setting up a target rate and monitoring by the provider |
| Risk | Potential to miss out on favorable market movements | Exposed to market rate fluctuations | Risk of not reaching the target rate before expiry |
| Best For | Businesses needing stability in cash flow for future payments | Individuals or businesses needing immediate currency exchange | Those with a specific rate target but without time to monitor the market |
Benefits of a forward contract
Hedge against sudden currency risks
Currency markets are volatile and foreign exchange rates can fluctuate throughout the day due to various political, economic and regional factors. The unpredictable movements of exchange rates can end up affecting your financial planning, hurting your bottom line and leading to uncertainty in business.
Forward contracts allow you to lock in exchange rates and add some certainty to your business transactions, protecting profits and improving predictability.
Better forecasting and budgeting
When you know exactly what exchange rates you’ll get for transactions, you can budget and forecast finances better. Your business can build more accurate budget projections, anticipate costs and make better business decisions.
Improved cash flow
Fixed exchange rates for a fixed period of time can stabilise your cash flow and lead to better planning. You can better manage your capex and streamline business operations without worrying about sudden changes in exchange rates.
Competitive advantage
With a stable exchange rate, you’re able to provide your customers with more stable, competitive pricing. It directly leads to a potential competitive advantage in international markets.
Book a forward contract with WorldFirst
With WorldFirst, you can book a forward contract and lock in exchange rates for up to 24 months. We help SMEs secure their future cross-border payment needs and protect their business from adverse foreign currency fluctuations.
Locking in an exchange rate with a forward contract means you know exactly what exchange rate you’re getting, for a set time. You can predict your cash flow to be more prepared, accurate and competitive with your planning.
If you already have a World Account, you can get in touch with your relationship manager to discuss the key terms of the forward contract which usually include:
- The currencies involved
- The rate of the contract
- Tenure (length) of the contract
- Determining whether you require a fixed, flexible, or window forward
- Initial margin requirements
If you are not ready to commit to a forward contract yet, you can also consider firm orders or spot contracts with WorldFirst to make quick, secure and reliable international payments at competitive exchange rates.
Disclaimer: The information contained is general only and largely our views. Before acting on the information you should consider whether it is appropriate for you, in light of your objectives, financial situation or needs. Although information has been obtained from and is based upon multiple sources the author believes to be reliable, we do not guarantee its accuracy and it may be incomplete or condensed. All opinions, estimates, mentioned products/services and referenced material constitute the author’s own judgement as of the date of the briefing and are subject to change without notice. WorldFirst shall not be responsible for any losses or damages arising from your reliance of such information.
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