Market forces determine exchange rates. And, volatility in foreign exchange markets is quite normal. Transactions are executed through Authorized Forex dealers. There could be various reasons that may make the markets volatile. It could be inflation, interest rates, political stability, fiscal policy, etc.
So, if you run a business that runs across different continents. Then, fluctuations in the foreign exchange market do pose a significant currency risk. It can impact both bottom-line as well as the top line of your business if not managed properly.
A forward contract
When we buy and sell a currency for immediate payment then, the rate at which the transaction executes is called as spot rate. But, if we want the transaction to be executed at a specified rate and time. Then, one can use a forward contract.
The forward contract helps a business insure itself against the volatility in the foreign exchange market.
Understand it with the help of an example. If a business requires 10,000 GBP in three months’ time. Then, it can enter into a three months forward contract. Here, we don’t consider a spot rate for executing the transaction. We use a forward rate. It is the rate that would help the business to receive 10,000 GBP three months later.
This brings stability to cross-border payments. We already know how much it is going to cost us in the future.
It is worth mentioning here that, it is quite possible that we may incur higher costs because of the forward contract. After three months, the spot rates get favorable to us. And, just because of the forward contract we entered earlier may cost us higher. But, there is another side to it as well. What if spot rates move in the opposite direction in three months’ time? In that case, it would cost us more with the spot rates.
We may never be sure about the costs we will incur in the future. But, with the help of a forward contract, we have completely done away with the foreign exchange market fluctuations.
The currency risks are much lower, we lock the rates earlier and can manage our finances better.
In conclusion, we have covered here a bit about the Forward contract.
