Rather than just sitting down and writing what we think a 'Forward' contract is and how you might go about using one to best effect, as you might expect and in an attempt to flesh out our more colloquial references to them, we have done some research.
We've looked at how others describe them... What regulators think of forward contracts and what they think are their associated risks and benefits; and we have also looked at how our current clients implement it/them in the course of their day to day currency activities and longer term risk and payment strategies.
So, in tried and tested GCSE fashion, let's begin with the online definition:
"A forward contract is an agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time."
1) It is a customised contract between two parties to buy or sell an asset at a specified price on a future date.
2) It can be used for 'hedging' or speculation, although its non-standardised nature makes it particularly apt for hedging.
Unlike standard futures contracts, a forward contract can be customised to any commodity, amount and delivery date.
3) A forward contract's 'settlement' can occur on a cash or delivery basis. Forward contracts do not trade on a centralised exchange and are therefore regarded as over-the-counter (OTC) instruments.
4) While their OTC nature makes it easier to customise terms, the lack of a centralised clearing house also gives rise to a higher degree of default risk. As a result, forward contracts are not as easily available to the retail investor as futures contracts.
Whilst you may have understood the check list above, not only does it bear repeating, but, some of what is said could stand to be translated into common English.
We added in the numbers in above list so that we can systematically go through each number and provide you with the explanation that might be relevant to how you could use a forward.
1) Customised means that the date on which someone pays for the forward is not arbitrarily agreed between the seller and the buyer. It is not a set or conventionally understood length of time - like a spot contract might be. Also, arrangements for margin or deposits is bespoke to the forward prior to booking it.
You (the client) set the date you want to complete a forward, but, you can also include provisions to shorten the contract term/length if you want to.
So, someone buying a house in France might set their forward maturity date a whole month later/after the completion date for the purchase just in case something meant they could not meet the completion deadline, as a precaution. Ensuring you use the right forward, you're not tied to that date 4 weeks later, but can shorten the contract length so as to take receipt of your currency on the day of completion or a fraction before if you wish - you've customised the contract to reflect the fact that you might want to close it off early.
Think of it like your forward buys a pot of currency. The terms of the forward means you can take out funds from the pot over the period of the forward until the currency is gone.
If you do not take funds from that pot then when the maturity date comes around you have the whole sum to do with as you will.
In some cases you might pay more for a forward that allows you to access or 'draw down' funds before the maturity date, but that depends on the terms struck with your broker.
2) Being useful for hedging or speculation essentially means that you can use a forward to protect yourself against a rate of exchange moving the 'wrong way'. By the same token, depending on the particulars of your forward(s), you can use it to gain from movements in rates.
We tend to think of hedging in a quite a literal way.
I am a UK (GBP £) furniture retailer/importer.
An arm chair costs me $20 from my chinnese supplier.
This means that as of right now a chair costs me £10 (hypothetically), because the rate might be $2 to £1.
I want to buy 500 chairs which, right now, would cost me $10,000 or £5000.
My supplier asks me to pay a 10% deposit for this order, with a further balance 90 days from now when the order is ready to ship.
If the rate of exchange is different 90 days from now, the amount of sterling I have to pay will be different. So, If I use a forward contract I can buy the $10,000 I need at the current rate which fixes my GBP cost at £5000.
Essentially I have put in place an obstacle (contract) to ensure that my costs cannot escalate even if the rate changes. To view this in a literal sense - I have placed a physical 'hedge' behind me, so that even if the rate moves, my hedge will not and my costs remain the same.
Now, that probably isn't how someone in the financial markets would necessarily illustrate what is meant by hedging. It is more to do with 'hedging one's bets' but, we prefer to look at it in terms of fixing your costs and securing your position.
A 'forward contract' 'forward buying' and 'hedging solution' are all the same thing.
3) In the context to deliverable currency 'cash or delivery' means that if you were to reach the point/date of maturity on the contract you could either elect to take receipt of the foreign currency secured, or you could opt to sell it back to the market.
I buy 500 chairs on a forward contract for $10,000 due to for settlement 90 days from now.
In 90 days the rate of exchange might be higher - so, sterling has risen in value (for instance £1 = $1.50 and 90 days later £1 = $1.60).
This means that it would actually cost me fewer pounds if I hadn't bought forward - because a spot contract would be at that higher rate.
Unfortunately I have pledged myself to this forward contract though, hence, I cannot drop the contract and buy the product at the better current/spot rate. Doing so would mean that I needed to exchange back the foreign currency amount i'd purchased 90 days ago. I committed to buying it, therefore I do have to pay for it.
If i didn't want the currency any more I would need to sell the USD bought on the forward contract and, as we have already said, the USD has lost value against GBP which means I would be unable to buy back the same GBP amount I had initially sold - the dollar being worth less. There would be a shortfall, a difference, cost to cover - sadly, as per the contract, that shortfall or difference is your responsibility to pay, and, you're therefore legally obliged to pay the amount you would have saved because of the rate movement - hence, the point of not settling the contract is moot. You'd have to pay us the saving because you're liable for any difference in the selling back of the USD you asked us to buy.
On the flip side, if the pound had lost value against the dollar (so, gone from £1 = $1.50 to £1 = $1.30)...a scenario I am specifically trying to protect myself from the effects of...the USD I have bought are, by the end of the contract, worth more in GBP than they were when I struck the contract.
If I were to sell those USD back into sterling I would be able to buy more pounds than I initially sold, which would constitute a profit.
In theory, this second scenario is what is meant by using a forward contract for speculation. However that is only theoretical because I engaged in a forward contract because I actually wanted to buy the aforementioned chairs. I was not entering in to the contract purely to bet on movements in the rate. Outright speculation would be akin to saying 'I am buying in now because I think that what I am buying will be worth more by the end of the contract.' This is a use of our services which is not permitted.
As it happens, brokers like Prime Cap do not and cannot engage in speculative activity. So, if someone came to us asking us to undertake the second of the two scenarios, then we would be duty bound to decline their business.
Where we find ourselves protected is that those clients who do use a forward contract and find the foreign currency is worth more at the end of the contract term, they must remember that they still have a product they need/wish to pay for.
They're tremendously unlikely to sell those dollars back for a GBP profit given they still need to buy that which they ordered 90 days ago.
4) Default risk is the the chance that the client does not pay for the currency bought.
So, in the scenarios above, where the rate of exchange rises, meaning one might be getting a more favourable rate on the spot market, you would be forgiven for thinking that a client would simply dump their forward contract because it is costing them more.
As we've said, you cannot do that because not only would it mean you're on the hook for the difference between the bought currency and the sold one, but also because currency contracts of this type are in fact legally binding.
The risk of default is the risk that you or any other client might simply refuse to pay the agreed amount for settlement.
To obviate this risk we tend to ask new clients or those with an as yet untested trading requirement to lodge a sum with us to serve as margin or a deposit.
We usually ask that client lodge between 5 and 10% with us.
We do this precisely because, depending on the currency being used and the length of time we are going forward, we can broadly estimate 5 to 10% to be the potential movement in the rate of exchange.
If my 500 chairs dropped by 10% in cost I might be inclined to renegotiate my contract - but, you cannot. That is the single and only caveat to a forward contract. Once done it is done. You do not have the 'option' to buy...you are committed; and, if you were to withhold settlement, we would be entitled to use the deposit amount to cover the differences in rates. You forfeit 10%.
Using a forward contract tends to be something we encourage corporate clients to use. We also happily discuss their uses with private clients who have structures or staged payments.
We must stress though that each matter is different and the proclivities of an instruction will always play a deciding role in whether one contract is used over another.
We invite you to give us a ring if you would like to take about the use of these products and contracts. You're never obliged to transact with us and you may be surprised to learn about how flexible these tools and resources are.