Tool of the Trade: Forward Contracts
by Veronica Stone on June 25th, 2007
Forward Contracts are a very useful tool for all of those importers/exporters who have to keep their margins tight.
For many companies the "head in the sand technique" is very popular. Order goods today, send over the deposit and then in 6 weeks when the goods are about to come into the docks and payment on the rest is due, that’s when they notice the market has moved and "oops" - it has gone the wrong way. Here is a quick but effective example:
A US company wants to buy goods from the UK. They are quoted at 100,000 GBP, and the UK company expects to be paid in Pound Sterling. The order is placed and the US company has 2 choices: one is to pay the deposit using a spot payment and pay the remainder on a spot payment in 6 to 8 weeks as per the contract, and the other option is to buy a forward contract which includes the deposit money.
If we had a price of $1.95 to the pound at the time of the order and a forward was booked, this would equate to a cost of $195,000. The US company would know from day one how much those goods from the UK were going to cost so prices in the states could be set accordingly.
However, if a spot price was used it might look something like this: 30% deposit, 30,000 GBP at $1.95 is $58,500 and then 6 weeks later the markets have moved and the dollar is weaker and the US company is now buying the remaining 70,000 GBP at $1.99 per Pound. A total of $139,300 added to the deposit paid means a cost of $197,800 for the same 100,000 GBP - a difference of $2,800 for doing the same job.
Now I know you can argue that the markets could move the other way and you could save a similar amount; but what we are talking about here is piece of mind and good business sense. If you know how much something is going to cost you in advance then you can plan your budget and your cost; but a major event in the world the day before you have to buy currency could be devastating on your business. Let me help you make your business more profitable - if you are exchanging currencies around the world we can help wherever you are based.