One way to hedge against exchange rate movements is to arrange a forward foreign exchange contract. This is an agreement initiated by you to buy or sell a specific amount of foreign currency at a certain rate, on or before a certain date.
Forward foreign exchange contracts are a secure and simple way of hedging when you're confident your deal will go ahead and the currency will be required.
Imagine you will need to purchase components worth €100,000 from a German supplier in 12 months' time. One euro might currently be worth 90 pence, meaning the supplies would theoretically cost £90,000.
However, if the euro increases in value against the pound to 95 pence over the year, the components would then cost you £95,000.
If the euro is expected to increase in value, you might agree a forward foreign exchange contract to buy €100,000 for £92,000 on a specified date. Of course, you'll lose out if the euro falls in value.
This solution suits almost all businesses that are at risk of losses stemming from adverse foreign exchange rates, especially those who:
- trade in a volatile market or to tight margins
- require large amounts of currency and so have a greater risk of losses resulting from unfavourable foreign exchange rates in relation to turnover
Advantages of forward foreign exchange contracts
- You're protected against any adverse movements in the exchange rate.
- You can set budgets knowing exactly how much the transaction costs.
Disadvantages of forward foreign exchange contracts
- You have to go ahead with the contract once you have arranged it, regardless of whether your circumstances change.
- Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate.
Forward foreign exchange contracts can be arranged through all the major UK clearing banks or independent foreign exchange dealers and can be tailored to meet your specific requirements. Your bank or financial organisation should be able to advise you.
The cost of a forward contract is usually built into the exchange rate.