Your Project Completes in Six Months. Your Locked Exchange Rate Doesn’t Have to Wait That Long.
You’ve priced a job using today’s exchange rate but you don’t need to pay the supplier until next spring. A forward contract lets you set that rate now, so the number in your budget is the number you will pay. Here’s how it works.
You’ve won a contract, but part of it depends on a steel shipment coming from Germany. Your quote includes the price of that steel based on the current Euro/US Dollar exchange rate. The trouble is, you won’t actually pay your supplier until the work completes in six months’ time. Between now and then, the markets will move, and that carefully-calculated pricing can fall apart.
What’s the Actual Problem Here?
This problem is all about timing. You have to commit to a price today, and you can’t risk overcharging just because the exchange rate might move against you in the interim. But, if the Euro strengthens against the Dollar, you’ll need more cash than you budgeted for, and that difference eats into your margin. You didn’t do anything wrong, but the Dollar weakened while you were getting on with the job.
So What is a Forward Contract?
A forward contract is a customized legally-binding agreement between two parties. You commit to buying a fixed amount of a currency, at an agreed rate, on an agreed future date. The contract covers exactly how much you will pay, with the full amount due on the settlement date. When the payment becomes due, you receive the cash at the rate you agreed, regardless of what the market has done since the contract was signed.
Does the Rate Move Against Me if I do This?
Once it’s locked, it’s locked. Even if the Euro gets more expensive moments after you lock, you’re protected because your price is now fixed. However, if the Euro gets cheaper, you will still pay the agreed rate and you won’t benefit from that swing. That’s the trade-off you’re making: you give up the chance of a better rate in exchange for certainty.
Do I Need to Pay It All Now?
No. Fixing the rate is not the same as settling the payment. You sign the contract locking in your rate today, and the money changes hands in the future (the agreed settlement date). One minor caveat: your provider will typically require a deposit to secure the contract.