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What is a Forward Exchange Contract?

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  • Written By: John Lister
  • Edited By: Kristen Osborne
  • Last Modified Date: 21 September 2016
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A forward exchange contract is an agreement to buy or sell foreign currency on a future date at an agreed exchange rate. This rate will apply regardless of what the going market rate is for currency exchanges on the day of the transaction. The forward exchange contract can be used to protect against variations in exchange rates, or as a form of speculative investment.

Unlike most forward-based financial products, a forward exchange contract may be marketed as a business tool rather than an investment. For example, one bank in the United Kingdom offers the product to its small business customers. In this case, the main benefit to the customer is not so much the possibility of winding up profiting on the deal, but rather the certainty of the exchange rate. This can be important for a company that signs a deal with a foreign customer to be paid in foreign currency upon future delivery of goods or services. The company can agree a forward exchange contract with its bank, thus knowing for certain how much the money it gets from the customer will be worth once converted into domestic currency.

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On a larger scale, companies that have a large presence overseas may use a forward exchange contract as a form of hedging. This means to protect against market movements going against one's interests by taking out a smaller investment that will pay off in such circumstances. A company that has stores overseas will do well if its own country's currency strengthens, and badly if its currency weakens. To hedge against this, it may take out a forward exchange contract that will leave it better off if the currency weakens. If the currency strengthens, it will of course lose some money on the forward contract, but the idea is to create a situation where the potential gains or losses are limited whatever happens, thus giving the firm added security.

It is also possible to have a forward exchange contract between two investors. One or both may be using it for hedging, but it's also possible one or both investors are simply gambling that they can better predict future exchange rate movements. If one of both of them are correct, they can complete the currency exchange at the agreed rate and then immediately turn a profit by changing the money back at the prevailing market rate.

In some cases, a forward exchange contract can be sold on to another investor before it comes due for completion. The price the new buyer pays for the right to take over the contract will depend on market movements in the meantime, and thus whether it is looking more or less likely that holding the contract when it comes due will prove profitable. In more complicated markets, a contract may change hands multiple times with the holders looking to make a profit as much from buying and selling the contract as from holding on until it comes due.

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