How do forward contracts work?
Unlikespot contracts, forward contracts can be seen as a ‘buy now, pay later’ arrangement that helps protect you against adverse fluctuations in the currency market. Let’s say, for example, that you know your company needs to purchase goods in six months’ time and those goods will cost you $1 million. Now, the price of $1 million in sterling is entirely dependent on the GBP/USD exchange rate at the time of purchase.
Example of a Forward Contract
Let’s imagine that you have done all your costing, pricing and budgeting and have calculated that purchasing $1 million at an exchange rate of 1.34 (GBP/USD) will cost you £746,268.
However, in six months’ time when you come to actually buy the dollars, the exchange rate is now 1.2800 (GBP/USD).
That same $1 million will now cost you £781,250. That represents a loss of£34,982and could have a direct impact on your profits, margins and bottom line.
In the example above we have cited an instance where you stand to lose – and it’s certainly worth pointing out that the market could move in your favour and $1 million could cost you less in six months’ time. However, can your business afford to take that risk? The peace of mind that comes from locking in a rate for the future – and the certainty you gain as a result – makes the business of costing and budgeting much more straightforward.
