A closer look at the ever-popular forward contracts and the different ways to use them…
According to a 2016 survey by Deloitte, 92% of businesses surveyed who use foreign exchange hedging instruments use forward contracts and non-deliverable forwards (NDFs) to manage their FX risk (1). Despite the many different options, products and structured products available, forward contracts still remain the most popular when developing hedging strategies.
We’re going to look at how businesses can get the most out of forward contracts by using them in different ways as part of their hedging strategy.
A rolling hedge is where a business will have a number of separate forward contracts in place with different expiration dates to cover a certain percentage (if not all) of their FX risk over a set time period. Businesses may book new contracts every week, month or quarter for a specified expiration date in line with their forecasted or committed exposure.
Here’s an example of the duration and level of cover a business may take using rolling hedges.
Forecast transactions
Hedge ratio
0-3 months
90%
3-6 months
70%
6-12 months
50%
12-18 months
30%
Along with the obvious benefit of offering protection against adverse currency market movements, this strategy ensures a business is constantly monitoring and evaluating its FX risk and FX exposure. In addition, it minimises period-to-period price deviations as the shorter the period between booking hedges, the less volatile the currency price will be from hedge to hedge.
Using open forward contracts, or flexible forward contracts
An open forward contract is more flexible than a standard forward contract. The latter commits a business to a pre-determined amount of currency on a fixed expiration date in the future.
Standard forward contract example:
ABC Ltd agrees to buy USD $135,000 from GBP at a rate of 1.35. The maturity date is set for December 31st 2019. On the maturity date ABC Ltd sends their counterparty £100,000 and $135,000 is sent to ABC Ltd’s USD account.
For some businesses this may be a challenge, as they are unable to forecast the exact date they will need to (or be able to) settle the contract.
One alternative is an open forward contract (or flexible forward contract) that allows the business to draw currency from the contract at any time within the specified contract period.
Open forward contract example:
ABC Ltd agrees to buy USD $135,000 for GBP at a rate of 1.35. The maturity date is set for December 31st 2019. ABC Ltd decides to draw down from the contract three times during the contract period: $35,000, $50,000 and $50,000. Each time ABC Ltd draws down from the contract, they send their counterparty the equivalent value in GBP at the agreed exchange rate and the USD are placed in ABC Ltd’s USD account.
If your business has certainty over future FX exposure but less certainty over timings, this slightly more flexible contract may be a useful part of your hedging strategy.
Using forward contracts with market orders
Businesses often use budgeted rates in order to set pricing and to formulate and monitor their hedging strategy. Sometimes achieving those budgeted rates is reliant on the timing of execution of the forward contract. Due to market volatility, the date/time a business books a forward contract can make a big difference to the rate of exchange due to normal currency market fluctuations.
What is a market order?
A market order is an agreement to buy or sell currency when a certain rate is achieved. Most business do not have the time or resource to watch the currency market 24/7, so this offers a way of catching peaks and/or troughs during times of higher currency market volatility such as overnight markets.
Typically there are two common types of market order:
Limit order: this is where an order is placed to automatically buy or sell currency when an exchange rate more preferable than the current market rate is reached. This type of order is used if businesses are hoping to catch a sharp peak in the currency market.
Stop loss: this is where an order is placed to automatically buy or sell currency when an exchange rate less favourable than the current market is reached. These are normally used as a way of protecting a business against losses if the currency market moves adversely.
Businesses can use market orders to execute forward contracts as part of their hedging strategy. If the market is declining, for example, then using a stop loss to book a forward contract may provide a business with longer-term protection against further adverse currency market movements.
When you consider all the ways forward contracts can be used within a hedging strategy, it’s clear why they are so popular among businesses. Figuring out how to manage your FX exposure can challenging, so it’s good to know there are experts available to help you develop the right strategy for your business. For more information speak with one of our experts today
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