Currency Forward Contracts
In short, a forward contract allows you to buy foreign currency at today’s rate, but only actually pay later, so you are locking in the exchange rate of today. If your business is heavily dependent on foreign currencies, this is a pretty good solution to help you lock in a good rate. Forwards can be locked in for up to 2 years. Here is a great example of how this works:
Company X is an importer in the US of Israeli machinery. Company X has just agreed to purchase 10 machines from Israel with a value of 4,000,000 NIS. This amount needs to be paid on delivery of the machinery in 6 months time. If the current US Dollar/Israeli Shekel rate is 3.70, Company X will need $1,081,081 if it was to convert funds today. However, seeing as they don’t need to pay the money for 6 months ,Company X wants to use these dollars for other purposes during this period. If Company X waits until 6 months time to convert Dollars to Shekels, it could cost considerably more or much less depending on the movement of the exchange rate.
If Company X does not want to take this risk, a forward contract is the right solution. They can fix a price at the current rate for 6 months time. In order to do this they will need to pay only 10% as a deposit to fix the rate, they will know the exact cost of the machinery now, and don’t have to worry about market fluctuations.
Keep in mind that there are disadvantages to this method. For example, if the rate goes against you, the contract still stands and you are required to purchase the currency at the agreed rate. Options do not have this issue as we will explain.
A foreign currency option is a financial instrument that allows the owner of the option the right, but not the obligation to exchange funds from one currency into another at a pre-agreed exchange rate on a specific date in the future. Here is an example of how options work:
Company Y is anticipating buying some machinery from Israel in 6 months time. If Company Y continues to expand the business it will need the machinery, however if business slows, it won’t require the machinery. Company Y is a UK based firm, and would need to convert Sterling to purchase the machinery which costs 1,000,000 NIS. The current exchange rate is 5.80, and based on this rate Company Y can afford to purchase the machinery. However, if the rate were to slip to 5.75 it would become unaffordable.
The solution for Company Y is an Option. Company Y purchases an Option to purchase 1,000,000 NIS for 6 months time at a rate of 5.80. In order to do so Company Y pays a premium. This premium is a fee and is non-refundable. Company Y now knows that IF it needs to buy the machinery in 6 months time it can afford to, as they have guaranteed a rate of at least 5.80.
The reason company Y has guaranteed a rate of at least 5.80 is as follows:
If in 6 months time the exchange rate is 5.40, Company Y will then take up the option of buying the currency at 5.80. If the exchange rate is 6.20 in 6 months time, Company Y does not take up the option of buying at 5.8 and instead buys the 1,000,000 NIS at the rate of 6.2.
By taking the option, Company Y would have saved themselves approximately £12,000 taking into consideration the cost of the option.
While a currency option does assist with hedging against exchange rate volatility and does not lock you in on a specific price, you are still required to pay a premium for the option which needs to be considered whether the rate moves in your favor or against you.