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Foreign Exchange Products - Forward Contracts
A forward contract is a low cost method of managing future currency exposure today. This is a hedging tool used by companies to manage the foreign exchange risk of anticipated future cash flows.
Many businesses are aware of their future foreign currency requirements today. A forward contract allows them to protect against future foreign exchange volatility by locking in a rate today so that the exact amount of funds required when payment is due (regardless of the FX rate on that day) can be projected. This eliminates the volatility risk of predicting what an FX rate might be when payment is due, and is in effect a “buy now pay later” agreement.
Advantages
- Ability to lock in an exchange rate today for future delivery (up to one year)
- Eliminates anticipated future foreign currency exposures
- Better than bank FX rates
- No security or margin deposit is required in some instances
Example
A tire manufacturer knows that he needs to purchase US$100,000 next quarter. Rather than take on unnecessary FX risk, the tire manufacturer decides to lock in today’s FX rates for the purchases he has to make three and six months from now. The tire manufacture locks in today’s rate of 1.0000 USD/CAD through a forward contract and agrees to buy US$100,000 for C$100,000 in three month’s time. If the exchange rate moves to 1.1000 in three months, the tire manufacturer still only has to provide C$100,000 to receive US$100,000 – saving the customer $10,000. More importantly, it provides the ability to predict its future costs allowing the manufacturer to sell those tires for C$105,000 and know that it will make a profit regardless of the FX rate in three months time.
If you have a future currency exchange requirement, why are you taking on unnecessary foreign exchange risk when you can lock it in?
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