Forward contract: protecting the business against currency risk

What is a futures contract?

Futures contract: definition

By definition, a futures contract is a financial instrument through which two parties agree to carry out a transaction at a future date in accordance with predefined terms.

This financial product is commonly used by companies to lock in exchange rates following the date on which this binding agreement is signed.

The payment is therefore confirmed and protected against any potential fluctuations in the foreign exchange market, which provides security for contracts denominated in foreign currencies and the associated margins. A forward contract thus enables a foreign exchange transaction to be carried out on a specific date, at an exchange rate agreed upon at the time the transaction is confirmed.

Futures contracts: who are they for?

Because forward contracts are primarily used to hedge currency transactions, importers and exporters are among the main players who are particularly keen on this solution.

Whilst some of these companies prefer to convert their currencies on a spot basis in order to settle their transactions by accepting the current exchange rate immediately or when settlement is due, a forward contract acts as a form of insurance within a hedging strategy and allows the parties to lock in an exchange rate (equal to the spot exchange rate at the time of the transaction plus a margin and swap points).

Good to know: In certain situations caused by interest rate differentials between economic zones, using a forward contract allows you to capitalise on the difference between the spot rate (spot exchange rate) and the forward rate (forward exchange rate), and thus benefit from more favourable exchange rates!

When deciding whether it is advisable to opt for a forward contract, there are certain factors to consider:

• the payment deadline for the order and the expiry date of the contract;
• the extent to which the company’s margins are exposed;
• the transaction volume in question;
• the interest rates for the relevant currency pair (depending on the country of import or export);
• the level of volatility of the currency pair in question.

In any case, whether or not a forward contract is in place, it is advisable for a company making regular cross-border payments to adopt a strategy to hedge against currency risks. Without such a strategy, exchange rate fluctuations could well have a negative impact on the company’s long-term financial health.

Please note: Just like large companies, SMEs and mid-market companies are perfectly well placed to use forward contracts for their foreign exchange transactions.

Futures contracts: what are the benefits?

In return for tying up a small portion of your company’s cash flow, a forward contract offers real benefits in the context of a multi-currency transaction.

For example, you might appreciate:

• the fact that cash does not need to be tied up until the payment date (as would be the case with a spot conversion), but only the collateral that may be required by the financial intermediary under the forward contract;

• the opportunity to benefit from favourable forward rates depending on the currency area involved in the transaction (with a forward rate that is better than the spot rate when the interest rate differential between two areas is favourable);

• protection against any adverse exchange rate fluctuations;

• securing profit margins.

However, the terms mentioned above may also prove disadvantageous to the contracting company; therefore, it is up to you to use your common sense to decide whether or not a fixed-term contract is in your best interests.

The different types of futures contracts

Fixed-term contract

A fixed-term contract is the most common and easiest-to-understand type of forward contract. It generally involves confirming a transaction in order to lock in the exchange rate for settlement at a later date.

This type of forward contract involves a binding agreement between the company and the bank and locks in the rates, thereby eliminating any exchange rate risk.

Flexible forward contract

The flexible forward contract (or Flexiterme) is more suited to companies whose transaction settlement date is not known in advance.

Although this type of forward contract fixes an exchange rate for a given amount in the same way as a standard forward contract, the company is also able to exchange all or part of that amount at any time during the predetermined period, before the contract matures.

Dynamic futures contract

A final type of forward contract is the dynamic forward contract. This comes in various forms, but always allows the company not only to protect itself against any adverse price movements, but also to benefit, to a certain extent, from favourable fluctuations.

The main types of dynamic futures contracts are:

• the dynamic full-participation futures contract, where the company can benefit fully from any rise in prices, but only upon expiry of the contract (subject to the payment of subscription fees);

• the dynamic partial-participation futures contract, where the company can benefit in part from any rise in prices, but only upon the contract’s expiry (with no subscription fees)

Fixed, flexible or dynamic: there are many different types of forward contracts available, and they can be tailored to suit any business situation; however, it is still essential to establish a proper currency risk hedging strategy in advance.

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