Small-medium sized enterprises (SMEs) are always looking for better ways to manage their budgets and better plan their spend. Forward contracts enable financial directors and their wider accounting teams to ‘fix’ an exchange rate for a set time period (up to 24 months) in the future to provide certainty on their profit margins.
How do forward contracts work at WorldFirst?
Forward contracts help protect SMEs against currency fluctuations without having to buy currency upfront on the spot market. A forward exchange contract with WorldFirst can be entered to facilitate payments for identifiable goods, services or direct investment. We offer a fully transparent pricing model, which sets the forward contracts being offered apart from the marketplace.
Types of forward contracts
The main types of forward contracts WorldFirst offers are Fixed, Window and Flexible forward contracts. WorldFirst can tailor a contract that suits the SMEs needs to make supplier payments or receive income from their customers in a foreign currency. These are outlined below [1]:
- A fixed forward contract allows an SME to agree on an exchange rate today, for a fixed amount, to be used on an agreed date in the future (which is the maturity date).
- A flexible forward contract gives businesses flexibility on when they take delivery or drawdown from a fixed rate of exchange throughout the contract up until the maturity date.
- A window forward allows buyers to purchase a specific amount of foreign currency within a range of settlement dates – known as windows – The windows are utilised to achieve a better exchange rate than that of outright forward contracts.
When might an SME use a forward contract?
It’s always important for SMEs to consider the commercial implications before committing to using a forward contract. Below are some examples of where a forward contract might be useful for a business:
- To hedge (lock in a rate) a rate to cover an invoice that is dated in the future.
- To hedge a rate to cover a percentage of a company’s forecasted currency requirements for future supplier payments
- To hedge a rate for project work that is paid in stages for up to 24 months.
- To protect forecasted exporting revenue from currency volatility
- When profit margins are tight and the ability to adjust the product and pricing is not an option.
- When a business publishes its prices on a website/brochure, and cannot re-price their product if the currency moves negatively against the business eating into their profit margin
So, what are the main pros and cons to consider?
Benefits of forward contracts
- A rate can be fixed, providing SME’s with certainty over their profit margins. The exchange rate would be locked in for the entire length of the forward contract, providing the buyer with a guaranteed rate of exchange.
- If the live market rate moves against the SME’s favour they will not be negatively impacted as they have hedged at a fixed rate.
- A deposit is usually required, and in WorldFirst’s case, SMEs can lock in a rate without tying up any liquidity by getting a credit line in place with WorldFirst. WorldFirst’s team of helpful FX specialists and 3rd party credit rating providers can set up credit lines on a case by case basis to cover initial deposits. Continue reading for more information on credit lines.
- WorldFirst will improve the rate when a drawdown occurs. This will reflect the difference in the interest rate between the two currency pairs and is known as the ‘interest differential’ (IRD). For an example, if one currency has an interest rate of 5% and the other has an interest of 3%, the IRD would be 2 percentage points. In the case of a negative IRD, your relationship manager will always be transparent with you when executing the trade.
Things to consider with forward contracts
- If a currency moves in your favour, you won’t be able to capitalise on that opportunity using the pre-book forward contract, and instead would need to book a spot contact to take advantage of the market movement.
- It is important to consider your risk appetite and evaluate your budget when pre-booking foreign currency. It is a tool to help you achieve your budget rate, however, it may be worthwhile considering other strategies if you are unsure of your requirements. It’s important to discuss your needs and potential risks with your dedicated SME relationship manager.
- If the market moves more than 4% a margin call may be required. To put it simply, if a currency swings adversely by a large amount, you may be asked to top up your initial deposit within 24-hours to re-establish the Initial Margin percentage level.
Margin calls and credit lines
A margin call is a requirement for additional funds to restore the originally agreed margin/ deposit percentage of a contract that has been affected by an adverse movement in the exchange rate [2]. WorldFirst allows an exchange rate to be locked in for up to 24 months and can require a small initial deposit ranging from 3-10%, depending on the length of the contract. We understand that obtaining a line of credit to enable you to hedge your currency exposure, without affecting your cash flow, can be a big issue. That’s why we are working with third-party credit rating providers offering credit lines on a case by case basis to cover the regular initial deposit.
Based on the latest financial information, our team of dedicated relationship managers would be able to discuss the possibility of a credit line to allow your business to fix a rate of exchange without placing the regular deposit. It is important to note that with a credit line you could still be margin called if the market swings adversely by a large amount, even if you have not placed a deposit.
SME business leaders challenges and insights
If we take a small business example of a company based in London importing women’s designer shoes from Italy who noticed that the GBP had weakened 10% against the EUR since the start of the year, their initial concern would be that they would have to increase the price of goods if the GBP/EUR continued to fall.
In this example, an SME like this would have estimated their currency requirement would total EUR 200,000 to buy next season’s stock, and so, using a forward contract, they would lock themselves into a rate to buy 200,000 EUR to settle in 6 months. At the time of executing the trade, they would only pay the 5% deposit required, EUR 10,000 (or GBP equivalent), to secure the contract, keeping more cash within their business to put towards other requirements. The currency forward also meant they would have avoided passing on their increased costs to their customers.
Forward contracts are important to consider for any business which makes or receives payments in foreign currencies. For example, a business which buys 2.5m Euros from Germany over a year will be subject to minute by minute fluctuations every time they make a Euro purchase. A forward contract allows SMEs to buy all of the Euros, or a portion of them at a fixed price, allowing them to budget safely. Over 12 months, it’s not uncommon to see exchange rates fluctuate over 15%, eating away at a company’s budget or profit margins.
A currency forward is a hedging product, so SMEs must understand how currency markets work and what the potential risks could be. WorldFirst can help businesses that transact up to or more than two million FX a year to fix an exchange rate for up to two years. The immediate benefit they’ll receive is no unexpected fees, great exchange rates and award-winning service from WorldFirst’s dedicated FX specialists.
What to do next
Speak with our team of FX specialists today who are on hand to help SME business leaders to understand which type of forward contract would best fit their needs. That team is happy to price up a range of fixed or flexible forward contract examples to show the benefit of the solution, discussing any possible exposure a business may experience while explaining the deposits and dates for the chosen contract to go live. Contact the team today and better manage your budget and spend.
[1]: https://www.worldfirst.com/uk/business/forward-contracts/
[2]: https://www.worldfirst.com/uk/support/payments-transfers/margin-call-explained-business/