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Foreign Exchange Hedging– Forward contract vs Forward Extra

by Darryl Hood | November 22, 2018

With increased levels of economic and political uncertainty, foreign currency markets can be volatile and unpredictable. For importers and exporters with foreign currency exposure, planning and forecasting can therefore be a challenge.

Foreign currency hedging is one way a business can protect itself from fluctuating currency rates.

To help clarify the difference between the two most common hedging products, we look at forward contracts and forward extras.

We also review their advantages and disadvantages to help you determine which is the most suitable product for your business.

What is a forward contract?

Forward contracts are a type of hedging product. They allow a business to protect itself from currency market volatility by fixing the rate of exchange over a set period on a pre-determined volume of currency. There are two different types of forward contract.

Closed forward contract

A closed forward contract allows a business to buy or sell a pre-determined sum of currency on a fixed date in the future.

Open forward contract

An open forward contract gives a business flexibility to exchange currency at any time within the contract period up to the value date.

For more information and examples on these products check out our blog

[foreign exchange hedging – your questions answered]

Forward contract advantages

  • Gives your business certainty over the exchange rate irrespective of the prevailing spot rate on maturity.
  • Helps a business protect its profit margins from foreign currency market downside.

Forward contract disadvantages

  • If the currency market moves favourably the business is still committed to using its forward contract at the agreed exchange rate which could be worse than the current market rate.

What is a forward extra?

A forward extra is an alternative hedging contract that allows a business to buy foreign currency at a “protection rate” in the same way as a forward contract, whilst also providing the opportunity to receive a rebate at the expiry date of the contract. In addition, the same flexibility exists that you would have with an open forward.

On expiry there are 2 scenarios with this product

  1. The spot rate is outside of your rebate range, with the contract having already been drawn down.

In this scenario the contract has already been completed, the rate the business has achieved is the pre-agreed protection rate and no rebate is applicable.

  1. The spot rate is within your rebate range, with the contract having already been drawn down.

In this scenario the contract has already been completed and the rate the business achieves is the better spot rate within the rebate range. As the contract has already been drawn down at the protection rate, the business receives a rebate to ‘make good’ back to the better rate.

Here’s an example;

Company ABC Ltd needs to buy $1,000,000, selling GBP, to purchase goods in 6 months’ time.

The forward rate for comparison is 1.31.

However, Company ABC Ltd has budgeted at an exchange rate of 1.30 but wishes to benefit should the spot rate move higher within the contract period.

The protection rate offered on the contract is 1.30 with a 6-cent rebate range to 1.36.

Forward extra scenarios on the expiry date

  1. The spot rate is below 1.30

Company ABC Ltd achieves a rate of 1.30 to buy $1,000,000

  1. The spot rate is above 1.36

Company ABC Ltd achieves a rate of 1.30 to buy $1,000,000

  1. The spot rate is 1.34 – within the 6-cent rebate range

Company ABC Ltd has already completed the contract, buying $1,000,000 at a rate of 1.30. The benefit of the contract now means that the rate achieved becomes 1.34. As a result, a 4-cent rebate is sent to Company ABC Ltd.

Advantages

  • Provides the business with certainty and peace of mind over the exchange rate.
  • Gives the business the opportunity to take advantage of a better spot rate on expiry subject to the market being within the rebate range.
  • No premium is payable upfront which may be required with other options products.

Disadvantages

  • The protected rate will always be less favourable than the forward contract market rate.
  • If the spot rate on the expiry date is outside of the rebate range, no rebate exists and you are committed to the protection rate.

For more information on foreign currency hedging check out our whitepaper

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