What is forward cover?
If your business trades internationally, for example as an importer or exporter, you run the risk of not only having to deal with your home country’s fluctuating market but with those of the countries you are trading with too. If you purchase a high volume of stock from an international supplier today but the invoice is only payable in 90 days, there is a lot of time in which the forex rates can change. You might end up paying more for the stock than what you budget for when you placed the order. This makes the true calculation of your input costs and your business’s future profit/loss margin near impossible and doing business becomes much more difficult. Luckily, there are Forward Exchange Contracts (FECs) to help mitigate the risk.
What is an FEC?
An FEC, also referred to as forward cover or a forward contract, is a contract entered into by two parties in which they agree to a fixed exchange rate for a transaction between two specific currencies. The transaction, however, will only be completed at a future date.
The need for such a contract springs from the potential volatility of the foreign exchange market where the value of currencies can be upended due to economic, technical, or political factors. When currency values fluctuate too much, it can have a very negative effect on international trade. The FEC helps to stabilise the currencies for a time regardless of external changes. It protects the traders from an unfavourable fluctuation between contract and payment date, but at the same time, should the currency fluctuate in the client’s favour, it also keeps them from capitalising on that possible gain. It is simply the compromise that needs to be made for the stability and risk management that an FEC provides.
There are three types of FECs depending on when payment should or could become due.
Fixed contract
The fixed contract has a specified realisation date on which payment as per the contract details will be made. This contract should be used when the parties know the exact date on which the payment will have to be made and the contract will be fixed on that date. It can be that payment can be made before the realisation date, but it is not expected.
Partially optional contract
This contract can specify a period in the future during which payment can be made. For example, the contract can be signed today with the expiry date being in a year from now. The agreement, however, is that payment will be made in instalments starting 6 months after the date signed and ending a year after the date signed.
Fully optional contract
With this contract, payment can be made any time from the date signed to the expiry date. It is an option that works well when you take one contract for multiple transactions, or you need some flexibility for the completion of a transaction.
How are the FEC rates calculated?
To calculate the forward exchange rate, you need to consider the following:
- S – the current spot rate of the currency pair
- r(d) – the domestic currency interest rate
- r(f) – the foreign currency interest rate
- t – the time of the contract in days
Different sources’ formulas might look slightly different, but ultimately, the same thing will be calculated. The formula can look as follows:
Let’s have a look at a real-life example. If we were to enter into an FEC between the ZAR and USD for a 90-day contract, in other words, we commit to pay for goods from an American company in 90 days, the variable could be:
- S = 15.4914
- r(d) = 4.75% (0.0475)
- r(f) = 1% (0.0100)
- t = 90
So, in 90 days when payment is due, it has been determined that the currency exchange shall be completed at a rate of 15.6362 regardless of what the true exchange rate is on that day.
In this case, the forward rate is higher than the spot rate. The foreign currency is thus at a premium which means it benefits the exporter that receives more than he would have at the current spot rate. If the opposite were true, the foreign currency would be at a discount, and it would benefit the importer by paying less than he would have at the current spot rate.
When you receive a quote for forward cover, it is not usually quoted with the total forward rate, but rather with the forward points – the difference between the spot rate and the forward rate. In this case, the forward points are 0.1448.
Final thoughts
The advantages of a Forward Exchange Contract are that the future price of the currencies is set, and it can help an individual or company plan and predict their cash flow with certainty. These contracts are customisable to individual situations and help mitigate risk. On the other hand, the fluctuation in the currency could have changed in such a way that you end up paying more than you would have without the contract. A contract with a very long timeframe can also cause some concern about non-payment or default. It is up to each individual to weigh up the pros and cons.
At Currency Assist, we provide forward cover to our clients and we will also advise you on all your options so you can make the best choice for you and your business.