Gain insight into FX Forwards – and protect your business against currency fluctuations

In a globalized world, where an increasing number of companies trade with customers and suppliers across borders, exchange rate risk is a significant factor that can significantly impact a company’s earnings, budgeting, and competitiveness.

A forward exchange contract is an effective tool for protecting against exchange rate fluctuations, as it allows companies to lock in a rate for a future transaction.

In this article, you will get an overview of an FX Forward, the different types available, key considerations, and the advantages and disadvantages involved when entering into a forward contract.

What is an FX Forward?

An FX Forward is an agreement between two parties to buy or sell a specific currency at a predetermined rate on a future date. This means you know the exact cost of an upcoming currency transaction – regardless of how the market develops. The contract's price is determined based on the spot exchange rate, the interest rate differential between the two currencies, and the contract's duration, which is mutually agreed upon by the buyer and the seller.

A forward exchange contract aims to lock in the exchange rate between two currencies at a specified future date, thereby reducing currency risk. This can be particularly relevant if a company is contractually obligated to pay a fixed amount for a future delivery of goods in a foreign currency and wants to secure the exchange rate in advance. By entering into a forward exchange contract, the company can protect itself against currency fluctuations – for instance, if a payment in foreign currency is due in three months but the company wishes to know the exact price in Danish kroner today.

Types of FX Forwards

There are several types of forward contracts, each suited to different needs and risk profiles:

1. Fixed Forwards

A Fixed Forward is the most common type of forward contracts. In this case, the parties agree on an exact future date for the currency delivery. It provides maximum predictability but less flexibility. For example, if you need to pay a supplier in USD on November 15, a Fixed Forward can lock in the exchange rate today instead of waiting until the payment is due. A Fixed Forward is an innovative solution if you know when to pay in foreign currency.

2. Open Window Forwards

An open window forward offers greater freedom, as the currency can be delivered at any time within an agreed-upon period, for example, between September 1 and December 31.

At kompasbank, we are the only provider in the Danish market offering this type of flexible forward contract. An open window forward allows for the settlement of all or part of the currency amount at any chosen time during the contract period, without being tied to a specific date or a single total amount. This gives companies greater flexibility when payment obligations have not yet been fully determined, but there is still a need to hedge against exchange rate risk.

3. Non-Deliverable Forwards (NDFs)

A non-deliverable forward is primarily used for currencies subject to restrictions on physical delivery – for example, the Chinese yuan (CNY) or the Brazilian real (BRL). Instead of exchanging the actual currency amounts, the parties settle the difference between the agreed forward rate and the prevailing spot rate on the settlement date in a convertible currency, typically US dollars (USD). If you wish to manage your exposure to currencies that are not freely traded on the global foreign exchange market, non-deliverable forward contracts offer an optimal solution.

What to consider before entering into a forward contract

Before you decide whether to make use of a forward contract, you should consider the following:

Lack of flexibility after execution

• The contract is binding, and you must complete the transaction at maturity, regardless of how the market has developed.

• This may result in a loss if the market rate at the time of settlement is more favorable than the rate agreed upon in the contract.

Choosing the amount and duration

• It is crucial to align the contract size and duration with your needs.

• A contract with too long a duration increases the risk of a mismatch between the contract and the actual requirement.

Liquidity and obligations

• You must ensure that you have sufficient liquidity when the contract matures.

• If you do not have the required currency at settlement, obtaining it on the spot market may incur additional costs.

Example: How an FX Forward works in practice

Challenge

A Danish company has purchased machinery from a U.S. supplier for 100,000 USD. The payment is due in three months, but the company wants to avoid the risk of the dollar appreciating, which would make the purchase more expensive in Danish kroner.

Solution

The company contacts its bank and enters into a forward contract. The bank offers a fixed exchange rate of 6.80 DKK/USD for three months.

Result

Regardless of how the exchange rate develops, the company will pay exactly 680,000 DKK (100,000 × 6.80) at maturity.

• If the rate rises to 7.00, the company saves 20,000 DKK.

• If the rate falls to 6.60, the company could have paid less, but it has avoided a potential additional expense.

This agreement provides the company with cost predictability and protects it against exchange rate risk.

Advantages and disadvantages of FX Forwards

Advantages

Protection against exchange rate risk (hedging): Locks in an exchange rate for a future transaction, thereby reducing uncertainty.

Liquidity certainty: Forward contracts help companies manage budgets and forecast expenses more accurately.

Flexible terms: Agreements can be tailored to specific amounts, currencies, and settlement dates to suit the company’s needs.

Disadvantages

The rate is locked in: Once the agreement is made, the exchange rate is fixed. This means the company cannot benefit from potentially favorable market movements. While forward contracts offer predictability, they may pay more than the prevailing market rate at settlement.

Complexity: A forward exchange contract requires a solid understanding of the currency market and may involve more administrative effort than spot transactions.

Are you ready to get started?

If you want to learn more about foreign exchange contracts and gain insight into how we can help your business develop an effective currency policy and manage exchange rate risks with the market’s most flexible and competitive solution, you can book a meeting with one of our currency experts here.