Forward Contracts
Forward contracts are a “buy now – pay later” solution to avoid currency market risk. The client can lock into a favourable exchange rate today for currency that it needs up to 2 years in the future.
A 10% deposit is required when booking the rate. The balance is only required on the delivery date of the contract and can remain in your bank account earning interest.
Example:
Company X is an importer in the US of Israeli machinery. Company X has just agreed to purchase 10 machines from Israel with a value of 4,000,000 NIS. This amount needs to be paid on delivery of the machinery in 6 months time. If the current US Dollar v Israeli Shekel rate is 3.70, Company X will need $1,081,081 if it was to convert funds today. However, seeing as they don’t need to pay the money for 6 months Company X wants to use these dollars for other purposes during this period. If Company X waits until 6 months time to convert Dollars to Shekels, it could cost considerably more or much less depending on the movement of the exchange rate.
If Company X does not want to take this risk, a forward contract is a perfect solution. They can fix a price now for 6 months time. In order to do this they will need to pay only 10% as a deposit to fix the rate, they will know the exact cost of the machinery now, and dont have to worry about market fluctuations.
Advantages:
- Ability to fix an exchange rate today, for any time period from 3 days up to 2 years.
- Protection from volatility in the exchange rates, which allows great efficiency in budgeting.
Disadvantages:
- If the exchange rate increases, there is a commitment to purchasing currency at the pre agreed rate. With an option this is not the case.
- 10% deposit could be used for other purposes during the contract period.
