Forward Contracts in Foreign Exchange
In the context of foreign exchange, forward contracts enable you to buy or sell currency at a future date. Then again, all foreign exchange derivatives do the same. There are differences among foreign exchange derivatives in terms of their characteristics. Forward contracts have the following characteristics:
Commercial banks provide forward contracts.
Forward contracts are not-standardized. This characteristic indicates that you can have a forward contract for any amount of money, such as buying €154,280.72 (as opposed to being able to buy only in multiples of €100,000).
Forward contracts imply an obligation to buy or sell currency at the specified exchange rate, at the specified time, and in the specified amount, as indicated in the contract.
Forward contracts are not tradable.
Who would use forward contracts? The non-standardized and obligatory characteristics of forward contracts work well for export–import firms because they deal with any specific amount of account receivables or payables in foreign currency. Additionally, these firms know their account receivables and payables in advance, so a binding contract isn’t a problem.
Take a look at the following two examples, to get some insight:
Suppose that you’re an American importer, and you have to pay €109,735.04 to a German exporter on November 12, 2012. You get a forward contract today to buy €109,735.04 at the dollar–euro exchange rate of $1.10 on November 12, 2012. In this case, you’re contractually obligated to buy €109,735.04 on November 12, 2012. On this date, you will pay $120,708.54 for it (€109,735.04 x 1.10).
Or suppose that you’re an American exporter, and you expect euro-receivables on November 12, 2012. Because an American firm cannot use euros in its daily operations, as soon as you receive euros, you sell them in exchange for dollars.
Therefore, you get a forward contract to sell euros. Suppose that your firms’ receivables amount to €246,947.40, and you get a forward contract today to sell €246,947.40 at the dollar–euro exchange rate of $1.10 on November 12, 2012. In this case, you will receive $271,642.14 on November 12, 2012 (€246,947.40 x $1.10).
Forward contracts aren’t tradable. This characteristic along with their non-standardized nature makes forward contracts unattractive to speculators.