Question

With the aid of appropriate illustrations, describe how forward contracts are used to manage exchange rate risk.

Answer 1

The uses for a forward foreign exchange contract
Forward foreign exchange contracts are useful for companies that have entered into a contract to either make or receive a foreign currency payment at a fixed point in the future. In either case, it will eliminate the transaction exposure that is one of the three core components of foreign exchange risk. It makes the rate certain, and typically allows the company to know exactly what the proceeds will be or, in the case of a purchase, what the cost will be. There is, however, a residual economic exposure.

The uses of a forward foreign exchange contract vary slightly depending on whether the company is an importer or an exporter.

For the importer
An importer will have entered into a contract to import goods. The importer will need to pay for these goods with foreign currency on a pre-determined date in the future. Entering into a forward foreign exchange contract will allow the importer to know what the cost of these goods are in domestic currency at the point of agreeing to purchase them. This will allow the company to establish the cost of these goods with certainty.

For the exporter
An exporter will be expecting a foreign currency payment on a specific date in the future. Entering into a forward foreign exchange contract will allow the exporter to know what the value of this future flow is either prior to, or shortly after, the contract to export is signed. Crucially, it allows the exporter to ensure that, although the price is set in a different currency, the company does know how much of its own currency it will receive and does not make a loss on the transaction after the foreign exchange transaction.

In both cases, forward foreign exchange contracts allow the company to eliminate the uncertainty associated with the future foreign exchange transaction. Such a transaction is particularly useful for companies that cannot hedge this exposure naturally, or that have to buy or sell at prices quoted in foreign currency. Some goods are traded in standard currencies (for example, oil is traded in dollars). In other industries, a dominant customer may require its suppliers to invoice in its operating currency and thus assume any consequent foreign exchange risk.

To illustrate this, let us assume that a French manufacturer has to pay its UK supplier £10m in three months time. The French manufacturer wants to fix the rate of exchange between the euro and sterling today. It could buy the sterling in a spot foreign exchange transaction today, which it would receive in two days time. It would then have to put the sterling on deposit for three months, before paying its supplier and might have to borrow the euros. Obviously interest earned on the sterling deposit could be used to offset any borrowing cost in euros. However this course of action would mean that the £10m would just stay on deposit for three months. This would still be regarded as working capital, but the deposit could be said not to be working very hard!

A forward foreign exchange contract, however, would allow the French company to fix the sterling-euro rate today whilst avoiding the need to place the £10m euro equivalent on deposit for three months.

The forward contracts involves 3 to 4 steps which will be performed by banks and all it needs is you have to enter into a contract with the bank .