In 2023, the United Kingdom imported goods valued at £895.8 billion, highlighting the nation’s reliance on international trade. For businesses that regularly import or purchase goods and services across borders, fluctuations in currency exchange rates can introduce significant financial risk. Managing this currency risk plays a key role in protecting profit margins and maintaining financial stability. In this article, we will explore forward contracts as an effective tool for businesses to hedge against currency risk, ensuring more predictable financial outcomes in the face of exchange rate volatility markets.
Need to Manage Your Currency Risk?
Rutland FX can help you manage your currency exposure with forward contracts and competitive rates.
What is a Forward Contract?
A forward contract in foreign exchange is an agreement between two parties to exchange a specified amount of one currency for another at a predetermined exchange rate on a future date. It allows businesses to lock in an exchange rate for future transactions, protecting them from potential fluctuations in currency values.
Unlike spot transactions, which involve the immediate exchange of currencies at the current market rate, forward contracts are designed for settlement at a later date. The key benefit of a forward contract is that it allows businesses to know exactly what the exchange rate will be when the transaction occurs, providing greater financial certainty.
Forward contracts with Rutland FX can be booked up to 12 months in advance, offering businesses the ability to lock in a competitive exchange rate. These contracts also provide flexibility, allowing you to draw down in tranches throughout the contract period to meet your financial needs.
Currency Budgeting with Forward Contracts
Forward contracts can play a key role in effective currency budgeting. Once you’ve set your budget rate, a forward contract allows you to lock in that exchange rate for a specified period, whether it’s for a month, quarter, or even a year. This eliminates the need to continuously update your budget if the exchange rate moves unfavorably, and it also reduces the necessity for pricing adjustments in scenarios of significant currency fluctuations.
Benefits of Using Forward Contracts for Currency Budgeting
- Budgeting and Financial Planning: By locking in exchange rates, businesses can confidently budget and plan without the uncertainty of fluctuating exchange rates.
- Protecting Profit Margins: Forward contracts help protect profit margins by fixing the cost of future transactions, regardless of market volatility.
- Cash Flow Management: Predictable costs improve cash flow management, ensuring that businesses have the necessary funds available when payments are due.
- Competitive Advantage: Fixed currency costs allow businesses to offer more competitive pricing, knowing they are protected from market fluctuations.
What is a Currency Value Date?
When you convert currency, the dealer or platform needs to know the “settlement date,” also known as the “value date” – indicating the day you expect to pay for your conversion. If you’re booking a trade before the cutoff time for that day and you plan to send the funds immediately to settle your conversion, you would set the value date as today.
- “Tod” (Today): This means you’re booking the currency for immediate conversion and should settle the trade at your earliest convenience.
- “Tom” (Tomorrow): This indicates booking the currency for the next business day; settle the trade by or before the cutoff time on the following business day.
- “Spot” (Today+2 days): This represents the longest settlement window before the trade is considered a forward contract. Settle the trade by the cutoff time on the third day.
- “Forward” (4 days or more): A trade booked with a settlement date of four days or more is considered a forward contract and requires initial margin.
Can an FX Forward Contract be Extended?
Yes, you can extend a Forward Contract by changing the value date to a future date if you need more time to settle the trade. You can also convert a “Spot” trade into a Forward contract similarly. If you’ve booked a trade with a value date of “Tod,” but the funds you’ve sent to settle your trade don’t arrive on time, don’t worry as there is a grace period to settle trades.
What is a Drawdown in Currency?
If a corporation booked a 6-month forward contract but needs to settle it early, perhaps due to increased payment volume or shorter supplier lead times than expected, the dealer would initiate a “drawdown.” This process involves bringing the value date closer to the current date, enabling the international payment to be dispatched earlier.
How is FX Forward Pricing Different from Spot?
In FX forward contracts, a financial institution takes on the currency position on behalf of the customer and holds it until the entire transaction is settled. This arrangement transfers the currency volatility from the customer to the dealer until the completion of the trade. To mitigate this risk, FX companies typically require a deposit termed “initial margin,” which is refunded upon settlement or applied towards the final balance.
The pricing of forward contracts entails various factors, including the duration and size of the forward, the volatility of the swap market, and the prevailing market conditions. Additionally, it takes into account the existing interest rate differential between the respective central banks of the currencies involved, along with the market’s forward-looking expectations for future interest rate differentials. These factors combined yield a value referred to as forward points. Forward points are subsequently added or deducted from the spot price depending on the duration of the forward. Consequently, the value of forward points is dynamic and undergoes daily fluctuations.
What is Initial and Maintenance Margin?
Initial margin refers to the amount of funds that must be available in your dealing account to act as collateral for opening a forward contract. Essentially, it’s the initial deposit required to initiate the contract. This margin serves as security for the dealer or counterparty against potential losses incurred by the client.
Maintenance margin, also known as variation margin or additional margin, is the extra margin required in the event that the value of the forward contract moves against you. If the market value of the contract falls below a certain threshold, additional funds must be deposited into the dealing account to bring the margin back up to the required level.
Initial Margin with Rutland FX
At Rutland FX, the initial margin typically starts at 5% of the transaction value. However, this percentage can be reduced based on the credit profile of the client. For clients with strong credit profiles, the initial margin can range from 5% to zero. It’s important to note that we currently do not offer 0% margin Forwards to individual customers; this option is reserved for corporate clients with robust credit standings and at least some trading history with us.
Regardless of whether your initial margin is 0% or 5%, we will always require additional margin from you if your forward contract moves significantly against you. This additional margin is known as maintenance margin.
Fixed Forward vs. Window Forward Contracts
When comparing fixed forward and window forward contracts, the key difference lies in the flexibility of the settlement date.
- Fixed Forward Contracts: With a fixed forward contract, the maturity date (settlement date) is fixed and cannot be changed. This type of contract is best suited for situations where you are certain that a transfer needs to be made on an exact date in the future. For example, if a business knows it must make a payment on a specific date, a fixed forward contract will lock in the exchange rate for that date, providing certainty and allowing precise financial planning.
- Window Forward Contracts: In contrast, a window forward contract offers more flexibility by allowing the settlement date to fall within a specified period rather than on a fixed date. This is ideal if the payment date might change and could potentially be made earlier. The flexibility of a window forward contract helps businesses manage foreign exchange risk more effectively when cash flow timings are uncertain.
At Rutland FX, all forward contracts booked are window forwards. This provides added flexibility without any additional cost, allowing clients to benefit from the ability to choose the settlement date within the agreed window, ensuring both certainty and flexibility in foreign exchange transactions.
What is a Currency Swap?
On some occasions, you may require additional time to settle a conversion. If a spot trade or forward contract reaches its maturity date and is not settled by the cutoff time, a swap occurs. This essentially involves selling the trade back and repurchasing it for a future settlement date. This process is handled by the back office and is not initiated by the customer. For instance, if a supplier encounters delays in shipping your goods, you might seek to extend your trade for a few extra days or, in some cases, weeks. A swap is the mechanism we utilise to extend the settlement date on a trade; it’s also sometimes reffered to as a “roll”.
What is a Non-deliverable Forward (NDF)?
A non-deliverable forward (NDF) functions similarly to a conventional forward contract, with the key difference being that it is cash settled instead of physically settled. In other words, at maturity, any loss incurred is covered by the initial margin (including maintenance margin if applicable), while any profit is returned to the client along with their initial margin. It’s worth noting that Rutland FX does not offer NDFs.
How do I book a forward with Rutland FX?
If your account is set up and enabled, you can book a forward straight away by contacting your account manager who will be able to provide you with an exact quote.
Still not sure?
If you are still unsure or have any further questions, please call us on 0203 026 0112 or request a callback below to discuss your requirements.