Understanding a Forward Exchange Contract (FEC)

If you ever traveled abroad, odds are you had to exchange currency. Yet, even if you planned that trip for months, odds are you didn’t prepare for this exchange immediately but simply accepted that currencies fluctuate.

With minor amounts, the currency risk is negligible — but for businesses that participate in global trade, currency fluctuations can make or break the profit and loss statement. For this reason, anyone with foreign currency exposure can use a forward exchange contract (FEC). Read more to learn what it means and how to use it to mitigate currency risk.

What is a Forward Exchange Contract (FEC)?

The FEC is an over-the-counter (OTC) agreement between two parties that have agreed to exchange foreign currency at some future date. The parties enter OTC agreements directly and without the supervision of an exchange.

FECs usually involve minor currencies that might be illiquid or otherwise unavailable. They’re a form of protection since the buyer hedges against the currency fluctuation risks that may arise during the contract period. This concept is handy when dealing with imports from emerging economies that might face an unstable geopolitical environment — but still be attractive from a business point of view because of abundant natural resources and affordable labor costs. Business entities using FECs usually include exporters of merchandise, exporters of capital, currency arbitragers and speculators.

How Does a Forward Exchange Contract Work?

Forward contracts involve two parties — a buyer and a seller, who agree to exchange currency at some point in the future. This period can be up to 12 months into the future for minor currencies, but major currencies like the U.S. dollar or the euro can work with multi-year timeframes.

Two parties need to define the following:

• Currency pair
• Nominal amount
• Expiration date
• Forward price

The currency price corresponds to the currency pair used in the transaction; the nominal amount equals the size of the transaction; the expiration date marks the day of the exchange; and the forward price ties the rate of exchange to a fixed ratio.

The parties define all the variables, which has a positive effect on both of them. Buyers completely avoid the foreign exchange risk, while sellers know their forward currency exposure and can speculate or manage that risk.

Forward Exchange Calculation

There are four variables involved in the forward exchange calculation.

S – the current spot rate of the currency pair

r(d) – the domestic currency interest rate

r(f) – the foreign currency interest rate

t – time of contract in days

The currency interest rate corresponds to a risk-free interest rate of the short-term bond.

Using those variables, the forward exchange formula looks like this:

Forward rate = S x (1+r(d) x (t / 360)) / (1 +r(f) x (t/360))

Consider the following example. A European company that wants to import goods from the U.S. is signing a deal with the manufacturer worth $5 million. The invoice is billable in 90 days, so the currency fluctuation could influence total costs, especially given both central banks' unpredictable interest rate decisions. Therefore, the company decides to enter a forward contract with its bank, specifying it to buy $5 million in 90 days at the current exchange rate.

With the spot price at 1.0007, the EU three-month rate at 0.5% and the U.S. three-month rate at 2.5%, the calculation would look as follows:

Three-month forward rate = 1.0007 x (1 + 0.5% * (90/360)) / 1+2.5% * (90/360)) = 1.0056

The difference between the spot rate and the three-month forward rate represents the premium the company pays now to mitigate a three-month currency risk from holding an unsecured exchange contract in foreign currency.

Benefits of Forward Exchange Contracts

Risk management is the main benefit for any business buying FECs. For a business, it allows to lock in the exchange rate within a specific timeframe and accurately mark down its financial results for the time period. This advantage is particularly favorable for small businesses that cannot withstand high currency fluctuations, especially if they’re conducting business with a country from an emerging market.

Disadvantages of Forward Exchange Contracts

The main issue with FECs is their illiquidity. Once they’re signed, they cannot pass to a third party. For a buyer, this presents an unfavorable situation if the value of the nominated currency goes down as they have an obligation to purchase at a predetermined, higher rate. This is an opportunity cost, offset by an equal risk from fluctuating rates.

Furthermore, if the underlying business transaction gets canceled, the buyer is still responsible for settling the FEC. Then, a new forward contract that reverses the transaction needs to offset this risk. This situation incurs additional fees, which can be quite hefty.

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