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How, Why & When to use a Forward Contract?


We love the chance to detail how a contract can be used to best effect.

For businesses, the answer to this question of 'when to use a forward contract' could simply be 'as often as you're able'. For details on the how and the all important 'Why?', read on.

To frame the post we need to do some scene setting and a recent discussion with a long standing client will do nicely:

Our client buys and then sell high-end 'construction hardware' - fibre glass, glass, venire, ballast and interior materials used in the manufacture and fit out of custom luxury vehicles, yachts and planes.

Although it sounds very glamorous, like any other business providing a service and creating a product, margin and the ability to predict costs form a crucial part of their forecasting. What their purchases end up being installed into or fashioning isn't the focus of their foreign currency needs.

Heretofore our client had used us to conduct 'on the spot' exchanges as and when their overseas suppliers invoiced them a foreign currency ampount. They benefited from the tighter margins we offer on our rates, the accessibility of our online platform and the responsiveness of our payments team.

NB. our online platform is very useful at 'this time of year' as their accountants can login and access trade and dealing statements, monitor the progress of trades and settlements and draw up all manner of data relating to the rates they've achieved over the last year.

Noticing that the value of the pound had improved by no small measure at the start of the year (2018), our client was eager to extend their ability to exchange at the improved rate. - and we were eager to explain to them how.

So, in consultation with our broking team they arrived at an estimate as to what sales and therefore what payments|exchanges they would need to make in the first two quarters of the year.

Although an estimate, the client undervalued the amount of foreign currency they expect to pay. This is and was sensible because it means that even if sales came in below forecast, the client had not committed to buying too much currency.

Conservatively they forecasted a foreign currency spend of approximately $475,000 between January 2018 and June 2018.

They did not have sufficient cash in the bank to buy all that currency now and pay for it today, so, we explained how a forward contract works:

We buy the $475k today, but we establish terms that allow our client to pay for the full amount some six months in the future if needs be.

Given that the $475k represented the collation of a number of payments they might need to make to suppliers, it is important to the client that they can draw down funds from that $475k 'pot' over the six month period as and when invoices come in from their suppliers.

A forward contract on the terms agreed enables them to do that and still use the rate fo exchange achieved today.

So, what does the client gain from conducting their transactions in this way?

+ . Their sterling (GBP) costs are fixed for 6 months.

+. The margin they apply to the products they produce does not need to change even if, day-by-day, the rate of exchange becomes less favourable; hence, they can afford to sell units at the same price when many of their competitors might not.

+. They only pay for what they use until the maturity date - so, what cash they do collect from sales can stay in their bank earning interest.

+ . Even if they underperform 'saleswise', they still have a buffer to the tune of the difference between the $475k bought and the total amount they expected to need.

If their fairer estimate was a spend of $600,000, but they underperformed by 25% (for argument's sake), they wouldn't mind.

+. If they outperform their sales forecasts they can buy the difference they need on the 'Spot'. Having one contract does not preclude the use of another.

One of the questions we tend do ask - in our heads rather than verbally because it can seem quite direct - is whether a business client would rather work off a definite and cemented cost base, or have to recalibrate their figures minute by minute, day by day, month by month.

All too often business owners are tempted by the idea that the rate of exchange might go in their favour before their next invoice is due. They have the money in the bank, but they want to see if the foreign currency amount might cost them a little less.

This mentality is totally understandable.

If you think you might pay less tomorrow then why would you buy today?

...therein lies the issue with this approach...

How can a business client, who specialises in whatever they specialise in (which certainly and assuredly is not the exchange of currencies) be sure that tomorrow will mean their costs are lower?

Our brokers have years and years of experience and you won't find them speculating as to where the rate of exchange will be tomorrow, so, how can you justify making that call with your business activities, especially in as volatile and uncertain a climate that the one today?

Do you buy in items from abroad?

Does supplier ask you to pay them in the currency they are based in?

Is the lead time on your purchases greater than 14 days?

Do you currently pay your invoices as an when they come in?

If your answer to any of these questions is in the affirmative then you may benefit from reviewing the way you make, receive, exchange and hold currencies.

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Prime Cap Payments Limited (T/A Prime Cap | Prime Cap Payments | Prime Cap Global Payments) is registered in England and Wales No: 10755730. Registered address: 27 Old Gloucester Street, London, WC1N 3AXPrime Cap is partnered with, and a programme manager of, Ebury Partners UK Limited who provide Prime Cap's FX and payment services.  Ebury Partners UK Limited is authorised and regulated by the Financial Conduct Authority as an Electronic Money Institution (Financial Services Register No. 900797) and is registered in England and Wales (registered no. 7088713). Registered office: 3rd floor, 100 Victoria Street, Cardinal Place, London, SW1E 5JL.  Ebury Partners UK Ltd is registered with the ICO with registration numnber ZA345828.