Forward Contracts 101: Why It Is Important to Protect Your Assets
The Importance Of Forward Contracts Amid COVID-19
Business owners and investors of all shapes and sizes have taken advantage of easy access to global markets over the years as the world embraced globalization. Savvy individuals who recognized opportunities exist worldwide have become masters of allocating cash to the best investment opportunity, wherever it may be.
To say that the coronavirus (COVID-19) disrupted global financial markets is an understatement. While financial media outlets are devoted to covering worldwide stock market collapses, the foreign exchange market has been overlooked, despite some large swings in short periods of time. But all hope is not lost as there are solutions for smaller businesses to protect against downside risk.
Oil Impacting Forex Markets
Many business owners are losing money by default of being on the wrong side of a foreign exchange pair.
For example, the Canadian dollar lost value against the U.S. dollar as the “loonie” has to deal with an unfavorable correlation with oil prices which dipped negative for the first time ever.
Meanwhile, where contango affects investors the most is with exchange traded funds that track futures contracts. Most notably, the United States Oil Fund (NYSEMKT:USO) has gotten the most attention lately as investors assumed it to be a tool to profit from rising oil prices. However, when the oil market is stuck in an extreme contango, it gets a lot harder to use the fund to profit.
One of the biggest misconceptions about the U.S. Oil Fund ETF offers exposure to the “spot” or cash price of oil. But this isn’t the case as the ETF tracks the front-month oil futures contract. The way it works is quite simple: two weeks prior to the front-month contract expiring, the USO fund will start buying the next inline future contract.
Instead, a better way for investors to play oil would be through a global giant that offers an attractive dividend for investors to wait. Examples include America-based Exxon Mobil Corporation (NYSE:XOM), England-based BP plc (NYSE:BP), or the British-Dutch company Royal Dutch Shell plc (NYSE:RDS.A).
Investors can buy BP and Royal Dutch Shell in U.S. dollars or through their London-listed stock. But this could create an unfavorable scenario where an investor loses out on potential profit if the British pound weakens.
Fortunately, investors can remove much of the guessing by protecting their foreign currencies through a forward contract.
What Exactly Is A Forward Contract?
A forward contract, also known as a forward currency contract, can be used by anyone to buy or sell a currency pair at a predetermined date at a guaranteed exchange rate. A contract can be taken out for up to five years or more for some of the largest currency pairs, such as GBP/USD. Other currency pairs could be limited to one-year in duration.
The vast majority of online money transfer services are able to facilitate their clients in setting up a forward contract. Typically, around 10% of the contract value will need to be paid upfront and the remaining 90% is due when the contract expires. In most cases, the contract can’t be canceled unless agreed to by both sides.
Example Of A Forward Contract To Protect Assets
Suppose a successful American small business owner wants to buy a beach-front vacation property in Mexico as it has fallen in price due to the coronavirus. The individual certainly understands the transaction will take longer than usual to close as the pandemic has brought the global economy and trade to a near halt.
The buyer and seller already agreed to a price of 24 million Mexican pesos ($1 million today) but to sign and close the deal in six months. In the meantime, the global foreign exchange market is operating as business as usual so the American could end up paying more in six months if the Mexican peso appreciates in value.
The American can set up a forward contract consisting of the following: they agree to exchange $1 million for 24 million Mexican pesos in six months from now. The agreement can not be altered or canceled and will remain valid regardless of the future exchange rate.
In other words, if the Mexican peso appreciates in value, the business owner will still pay $1 million for the property because of the terms of the contract. On the other hand, if the peso lost 10%, they could have ended up paying $900,000 for the home.
But this is the nature of the forward agreement. It is specifically designed to avoid extra expenses and costs but with the assumption that there can be no savings.
Bottom Line: A Forward Contract Is More Important Than Ever
Individuals who want to hold on to their global stocks and business owners who want to conduct business across borders face a difficult decision when it comes to foreign exchange rates in this turbulent environment. The current coronavirus-induced volatility in the foreign exchange market implies currencies can move very fast in either direction. A small and sudden move in the wrong direction could be the catalyst that translates to financial ruin.
The fact that a forward contract dictates the user gives up any upside potential is worth it for the vast majority of people. After all, they aren't currency speculators and have a responsibility to themselves and stakeholders to minimize potential losses -- even if it means walking away from potential gains.
Disclosure: None
