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Andro Matugas-Barnes
Jul 06 2018

FX Forwards: Brave world for SMEs

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FX Forwards: Brave world for SMEs
<blockquote> <p>It&#39;s 2018:&nbsp;a decade since the GFC, yet many SMEs stand significantly exposed to foreign exchange&nbsp;risk.</p> </blockquote> <p>With proper FX Risk management, firms can enhance their strategic decision-making process&nbsp;by assessing the costs, benefits, and risks associated with currency fluctuations. FX hedging&nbsp;does not have to be complex to be effective, it can just be as simple as a <strong>Forward Contract</strong>.&nbsp;</p> <p>The heart of any FX risk management strategy is likely to be the forward contract, which is a contract to&nbsp;buy or sell currencies at an agreed exchange rate on a particular date in the future.</p> <p><strong>FX FORWARDS</strong></p> <p>A forward contract is a straightforward currency hedging tool, which allows you to lock in a current&nbsp;exchange rate, while delaying the settlement of the contract for a period up to 12 months.&nbsp;</p> <ul> <li><strong>Minimise Volatility</strong> - Forwards are particularly attractive for SMEs that seek a symmetrical payoff&nbsp;profile relative to the spot foreign exchange rate, where the hedge achieves largely equal and&nbsp;offsetting gains and losses related to the underlying foreign exchange exposure. Forwards are by&nbsp;far the most effective way for eliminating FX gains and losses to the greatest extent possible.&nbsp;</li> <li><strong>Preserving Cash Flows</strong> - Forward contracts don&rsquo;t require an full upfront premium to be paid,&nbsp;unlike an option. However, a forward contract will almost always finish in either an asset or&nbsp;liability position at maturity depending on the ending spot rate, which may require a 10%&nbsp;deposit payment to be made at the beginning of the contract.&nbsp;</li> <li><strong>Distinguishing Characteristics</strong> -&nbsp;3 key distinguishing characteristics of forward contracts are their&nbsp;forward point premium or discount, the lack of upfront cost, and the symmetrical payoff profile&nbsp;relative to the spot foreign exchange rate.&nbsp;</li> </ul> <p>A forward contract is no different to a standard currency spot trade, except that the settlement date is&nbsp;pushed forward into the future, and the rate is adjusted slightly to account for the interest rate&nbsp;differentials between the two currencies in question.</p> <blockquote> <p>FX forwards help investors manage the risk in the currency markets, by locking in the future exchange&nbsp;rate and the date on which they will make a foreign exchange transaction.</p> </blockquote> <p><strong>By using FX forward&nbsp; contracts,&nbsp;investors can:</strong></p> <table align="center" border="0" cellpadding="1" cellspacing="1" style="width:800px"> <thead> <tr> <th scope="row"> <ul> <li style="text-align:left">Protect &#39;costs&#39; on products and services purchased abroad,</li> <li style="text-align:left">Protect &#39;profit margins&#39; on&nbsp;products and services sold abroad, and</li> <li style="text-align:left">&#39;Lock-in exchange rates&#39; as much as a year in advance.</li> </ul> </th> </tr> </thead> <tbody> </tbody> </table> <p><strong>RISKS</strong></p> <p>The downside of a forward contract is that on the day of settlement you are obligated to settle at the&nbsp;predetermined price. In exchange for this rate certainty, you forgo the ability to participate in the spot<br /> market, if the prevailing market rate is more favorable than your predetermined forward rate.&nbsp;Additionally, on occasion you may be required to post margin, if an outstanding forward contract is&nbsp;considered out of the money compared to current market rates.&nbsp;</p> <ul> <li><strong>Credit risk</strong> - as in most financial instruments, one of the major risks associated with an FX&nbsp;forward contract is credit risk. In the case that one of the parties is unable to fulfill its obligation,&nbsp;the other party will have to sign another contract with a third party, thus being exposed to&nbsp;market risk at that time.&nbsp;</li> <li><strong>Exchange rate risk</strong> - another major risk with FX forwards are potentially unfavorable movement&nbsp;of exchange rates. By locking-in the exchange rate at which the currency will be bought, the&nbsp;party forfeits the opportunity of profiting from a favorable exchange rate movement.&nbsp;Additionally, unfavorable exchange rate movements may take away further opportunity for the&nbsp;party to profit (in the face of opportunity cost!)&nbsp;</li> <li><strong>Interest rate risk</strong> - since the price of a forward contract is dependent on the differential between&nbsp;the interest rates that can be earned with the two currencies, variations in those rates can&nbsp;change the price of the contract. If the party has already signed a forward contract, it forgoes the&nbsp;opportunity to sign one at a lower rate in the case of favorable change in interest rates.</li> </ul> <p><strong>CONCLUSION</strong></p> <p>If you need protection from FX currency markets, Forward Contracts could be the perfect solution. You&nbsp;are able to lock in an exchange rate for the purchase of currency at a future date, or over a range of&nbsp;dates, up to a maximum of 12 months. Forward Contracts help protect your business against the risk of&nbsp;market fluctuations, without having to commit cash flow to buying currency in advance. A refundable&nbsp;10% deposit may be required to set up a Forward Contract, depending on a number of factors&nbsp;surrounding the risk of the Forward requirement.&nbsp;</p> <p>Instead of letting the markets determine your financial future, our highly professional FX team can help&nbsp;you manage the markets. Forward Contracts, in the right hands, can provide you with the certainty and&nbsp;protection you need.&nbsp;</p> <p>Although many businesses prefer to buy most of their foreign currency using Forward Contracts, it is&nbsp;always worth discussing the full range of FX solutions with our FX Team &ndash; working together, we can then&nbsp;create the perfect strategy for your business.&nbsp;</p>

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