In recent weeks we have seen the pound rock against EUR from a low 1.10 in September to a welcome but pretty lack lustre high of 1.1450 in early October; and now back.
These moves may not seem like much when you look at them on a screen or hear about them at the end of News Night, but, for businesses on the ground who are forecasting their costs and trying to make payments, these movements can be both costly and very unsettling.
So, what can a forward contract do to help you? Are they right for your business and what do you need to know before using one?
Let's set the scene:
Over the last few weeks or we've been discussing on The Prime Cap Daily that sterling had risen against the euro and subsequently dropped back somewhat.
In early October (18) it had climbed from a resolute 1.12 to a high of 1.1450.
This literally means that for a business buying $150,000 worth of stock for the Christmas season, the GBP cost went from £133,928 to £131,004 almost overnight. YAY.
A business could make a saving of literally £2924 just from the movements in the rate of exchange over the past few weeks.
Now, neither Prime Cap nor the company in our example could have confidently predicted that the pound would move higher. For one thing, the move was on the back of, at the time, unforeseeable confidence about the proximity of the UK government to a deal with the EU.
The reason why the rate went up isn't really the point of the matter...it is rather that GBP moved up by sufficient a margin as to afford the business in question a meaningful saving.
Generally, when we talk to business clients we emphasise the point...
...'GBP moved up by sufficient a margin as to afford the business in question a meaningful saving...'
...to the exclusive of almost everything else.
We are not speculators and, whether you're a client or not, familiar with our technique and rhetorical style or not, you will find that we focus on the change in the rate - the margin by which it has moved - rather than the reason behind the move itself.
So, the business that has saved this near £3000 amount...what can they do?
The way to approach making use of the move up in the currency you hold (therefore the currency in which you're spending your money) depends rather on a few key things:
1) cash flow/liquidity
2) lead time
3) the terms of your contract
3) settlement risk/protection
1 :: Do you have the money sat in the bank already to pay for your $150k of stock?
2 :: How long is the lead time between when you are invoice for the stock and when you have to pay it?
3 :: Do you have to pay in instalments - ie. 50% now, 50% on delivery?
4 :: What protection do you have should your customer default (or indeed your supplier)? Do you take a deposit from your customer?
One thing that is sometimes overlooked by both currency brokers and clients is that the rate offered for a forward contract is not the same rate offered for a spot or same day contract.
When we go to 'the market' to ask our counter-parties to give us a trade price on a forward contract, our counter-parties will look at a couple of things that wouldn't be factors were we asking for a rate on a simple vanilla spot contract.
Interest rate differentials is one thing. Would the counter-party be making money holding a foreign currency with a higher rate of interest, than not?
Clients also have to consider that because forward contracts are not available to smaller businesses (or individuals) the broker is inclined to,
and probably entitled to, incorporate a premium into their margin. The supply of these contracts is essentially limited to brokers and the demand increases at times of distinct turbulence or volatility in the markets.
We recommend that you do not let the difference between a spot rate and a forward rate put you off considering a forward contract in earnest.
The rate is not really the point of a forward. What you are buying is protection from costs going up from where they are today.
If you have a firm order and have been invoiced by your supplier, then perhaps it makes sense to fix your sterling costs now?
If you have a UK supplier whose lead time is 90 days and the suppliers tells you that the cost of the order may go up or down by as much as 10% before they ship to you (due to possibly fluctuations in the cost of oil, freight, their raw materials etc. etc. etc), but you can firmly fix the GBP cost today by paying 1% extra on top of the invoiced sum...what would you do?
9 times out of 10 we thinks businesses would rather do without the uncertainty that goes with waiting 90 days.
This is the approach we always urge business clients to adopt.
A forward contract, although fractionally more expensive that a spot contract and although requiring of a nominal deposit, means you can totally and absolutely rely on the fact that you will not have to pay more when you actually settle the invoice.
With a UK supplier, you might choose to delay paying them until closer to that 90 days deadline because you have cash in an interest bearing vehicle...or because you're waiting for someone further up the chain to pay you.
Those considerations can be factored into your use of a forward contract too...in fact, they work far better when coupled with a forward contract.
The entire reason and nature of a forward is that you fix the rate now, pay a nominal deposit, and then settle the contract at a time in the future.
We invite you to give us a ring to chat through what has been going on across the currency markets of late.
If you still don't understand how you might use a forward contract, or you think your business should consider hedging their exposure, then we would be delighted to hear from you...if you'd rather not speak with us, then do subscribe to The Prime Cap Daily.