Understanding Forward Contact and its Role in International Business

 James Broth
  Jan 11, 2018

There are many tools created to help businesses minimize risk and increase the odds of profitability. Unfortunately, many businesses, small businesses especially, do not leverage the tools at their disposal. Many small business owners are either ignorant about the existence of such tools or they think that learning how to use such tools is more stress than it is worth. In this piece, I will shed light on the simple but powerful 'Forward Contract" and the important role it plays in international business.

Forward contract in international business

A forward contract is simply a contractual agreement between two parties to buy a given volume of an asset at an agreed price, on a date set in the future. The beauty of the forward contract is that it can be customized as a hedging or speculative tool for any commodity or asset.

Hence, the forward contract has developed to become an important tool for hedging currency fluctuations in international business. A U.S. small business that has trade relationships in Europe must always pay attention to currency conversion risks between the USD and the Euro for headwinds or tailwinds as the case may be. The same is true if you have business dealings in other countries in South America, Middle East, Asia, or Africa.

For instance, the USD to Euro forex trade is somewhere around $1 (USD) to 0.8284 (EUR). Hence, $10,000 will buy you goods worth 8,242 EUR in Europe. However, if the rates drop to $1 to 0.8010 EUR, the same $10,000 will only buy goods worth 8,010EUR; hence, you already have a $274 setback (loss) from the point of purchase.

Now, if you have reasons to believe that the EUR will strengthen against the USD in the coming months, you can use a forward contract to lock down the current $1 to 0.8284 rates, and you won't have to worry about lower FX when you need to exchange USD for EUR.

For importers, a forward contract helps to know how the exact costs of good you want to import so that you can know if the deal makes business sense. A forward contract helps you to know how much the importation will cost you at a predetermined date in the future; hence, you'll be able to know if you'll still be able to resell the good at a profit in your home country.

For exporters, payment for exported goods is sometimes paid at a date in the future. The problem, however, is that you can never be sure what the value of your earnings will be when the payment is eventually released because of fluctuations in exchange rates. A forward contract can help you 'lock down' the rate so that you can technically know how much to expect when your payment is released at that future date.

Using forward contract to manage FX risk

Using forward contract in international business is a smart strategy for managing FX risks. Unfortunately, some small business owners forego the certainty that the forward contract brings to FX rates because they don't understand the pricing of the forward contract.

FX brokers price forward contracts using three simple factors; namely, the current spot price of the currency, the interest rate differentials between the currencies, and the time until the maturity and execution of the contract.

A simple forward contract calculator can pull up the values of the spot price and interest rate, you'll only need to adjust the forward date to know the rate and take action to lock in the rate. For what it's worth, you can use a forward contract to lock down exchange rates for as much as 12 months. Hence, business will find it easier to manage FX risk against future events.

The forward contract is particularly useful for managing risk in periods of economic and geopolitical uncertainty. The Brexit vote of 2016 was a particular case in point result in a 'Yes' vote that saw the Pound Sterling fall to a 31-year low. People engaged in international business should brace up for more uncertainty ahead as Israel-Palestine conflicts, separatist agitations, and an unpredictable Trump continues to move the FX markets.

Understanding Forward Contact and its Role in International Business

James Broth

James Broth is a business writer, mentor, and personal finance advisor. He has been consulting for SMB owners and entrepreneurs for the past seven years.

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