Brief Introduction About Foreign Exchange Contracts
A foreign exchange contract is known to be an agreement under which a business agreed to buy a certain sum of foreign currency on a particular future date. The buying is made at a predetermined rate of exchange. Through entering into this contract, the buyer could protect itself from following fluctuations in a foreign currency’s exchange rate. The intention of this contract is towards hedging a foreign exchange position in the direction of avoiding a loss or to anticipate upcoming changes in an exchange rate to generate again.
Forward exchange rates could be obtained for 12 months into the future; quotes for major currency pairs (like dollars and euros) could be obtained for as much as 5 to 10 years in the future.
Who Takes Foreign Exchange Contracts? – People Involved
Foreign exchange contracts are agreements that are made between two individuals or businesses that govern the purchasing and selling of any asset or commodity at a specified time in the future for a set price.
Purpose of Foreign Exchange Contracts
This agreement required to purchasing or selling, an asset at a certain time for a set price. By entering into a foreign exchange contract, a corporation could make certain that a definite future liability could be settled at a specific exchange rate. Forward contracts are usually customized, as well as arranged between a corporation and its bank.
Contents of Foreign Exchange Contracts
In a foreign exchange contract, one party will agree to deliver a specified sum of one currency for another at a stated exchange rate at a designated date in the future.
- The specified exchange rate is known as the ‘forward rate.’
- The designated date at which the parties should transact is known as the ‘settlement date’ or ‘delivery date.’
- An investor also takes a position in the market through purchasing a forward contract is known to be in a ‘long-position.’
- In case the investor’s opening position is the sale of a forward contract, the investor is known to be in a ‘short position.’
- Where the expiration is fixed for other than a round number of months, the currency forward contract is known to be with ‘broken dates.’
- The difference among the forward and the spot exchange rates is known as the ‘differential.’
- The rate of the forward contract is quoted at ‘premium.’
- In case the forward rate is quoted at a rate lesser than the spot rate, it is quoted at ‘discount.’
How to Draft Foreign Exchange Contracts?
The foreign exchange contracts comprise the following elements:
- The spot price of the currency
- The bank’s transaction fee
- An adjustment (up or down) for the interest rate differential amid the two currencies. In essence, the currency of the nation has a lower interest rate would trade at a premium, while the currency of the nation having a higher interest rate would trade at a discount. For instance, if the domestic interest rate is lower than the rate in the other nation, the bank acting as the counterparty adds points towards the spot rate, which increases the cost of the foreign currency in the forward contract.
A foreign exchange contract is an arrangement that permits you to transfer money at some time (up to 12 months) in the upcoming at an exchange rate that you agree to now so that you recognize what the exchange rate would be at the time the transaction takes place. This permits you to avoid the threats and uncertainties related to adverse exchange rate movements.
Benefits and Drawbacks of Foreign Exchange Contracts
A foreign exchange contract might be beneficial for business as well as individuals if exchange rates are mainly attractive now, and you want to lock in that rate towards hedging against uncertainty in the future. This could be especially helpful for small businesses who would want to keep their cash flows predictably when purchasing or selling overseas.
- Safeguard against currency exposure, exchange rate movement, devaluation, etc
- No cash flows except on maturity date
- Costing is effective as well as determined in advance
- Foreign exchange contracts are beneficial for both speculation and hedging, but they are specifically good for hedging in the worldwide market.
However, a Foreign exchange contract precludes you from taking benefit of further useful movements, if your currency pair continues towards moving in a profitable way. To avoid missing out on any profitable movements, some individuals use this contract for a smaller portion of their total payment (e.g., 50%) as a way to hedge against volatility.
What Happens in Case of Violation?
The main difficulties with Foreign exchange contracts related to their being customized transactions that are aimed specifically for two parties. Due to this level of customization, it is hard for either party to offload the contract to a third party. Also, the level of customization makes it hard to compare offerings from different banks, so there is a propensity for banks to build remarkably large fees into these contracts.
Finally, a corporation might find that the underlying transaction for which a foreign exchange contract was made has been canceled, leaving the contract still to be settled. In that case, the treasury staff could enter into a second foreign exchange contract, whose net effect is to offset the first foreign exchange contract. Though the bank would charge fees for both contracts, this arrangement would settle the corporation’s obligations. An added issue is that these contracts could only be terminated early through the mutual agreement(1) of both parties towards the contracts.
A Forward Exchange Contract is a contract that is made between two parties whereby they promise themselves to exchange a stated amount of one currency for another at an agreed rate of exchange, settlement(2) of which happens on a fixed date in the future.