Why in times of volatility you should know a tool named forward contract

THIS decade has been a splendid time to be an investor. From 2010 to now, the value of the Dow Jones has more than doubled.

However, this smooth climb in valuation appears to have ended for now. The trade war between China and America, Brexit, and slowdown concerns have introduced uncertainty to markets.

This volatility has also had an impact on Forex. Uncertainty over USA-China trade talks, Theresa May’s Brexit deal, and the global economy have made key currency pairings unstable. There isn’t much cause for alarm for buy and hold investors – through history, there have always been stormy periods.

It’s a different story altogether if you own a small business or purchasing real estate abroad. Sudden movements in currency pairings could potentially lead to cash shortfalls. These anomalous market movements can cause avoidable headaches on both sides of a transaction.

As a consequence, forward contracts have seen an increase in popularity. In this blog, we’ll explain their importance to international commerce, and how you can use them for your transactions.

What is a forward contract?

A forward contract is an agreement to buy/sell a commodity at a set price in the future. These arrangements minimise risk – if the exchange rate shifts too much, the buyer/seller could end up short money.

Those familiar with markets will notice how similar they are to futures. Like forwards, futures contracts are agreements to buy/sell something at a fixed price at a later date. However, they differ in fundamental ways – for one, futures are traded on exchanges, while forwards are over the counter (OTC) instruments. Secondly, futures can be settled at any time, while forwards are paid on the date of maturation.

Despite their risky nature, parties committed to a transaction prefer forward contracts. Unlike futures (whose terms favour speculators), the settlement of a forward contract is locked in. As a result, those exchanging currency won’t have to worry about the other side bailing halfway through the deal.    

Forward contracts: a must for frictionless transactions in 2019

Before 2016, our political landscape was relatively predictable. Since then, things like the chaos of Brexit have wreaked havoc on currency markets.

When news first broke of Leave’s victory in 2016, GBP plunged 10% against the USD. Fast forward one month, and GBP/USD recovered to 1.34, only to give back those gains a fortnight later. Volatility has actually calmed lately, but with the Brexit deadline looming, a drop of undetermined severity is likely.

Let’s say you just recently moved to Spain. You’re about to move the contents of your current account overseas but are rightly nervous about exchange rate fluctuations. A Brexit deal, a political turbulence in Spain, or developments that make no-deal more likely could trigger them.

In this environment, sending money the usual way has become riskier. A forward contract provides a hedge against the worst case scenario – the GBP plunging to parity with the EUR. You won’t get the best price, but a forward contract limits losses caused by a sudden drop in GBP/EUR. 

Money transfer companies offer easy access to forward contracts

After learning about forward contracts, you’ve decided to move forward with buying property in Spain, so you move money your UK bank account to your Spanish bank account. There’s just one problem – unlike futures, forwards cannot be purchased from a bank as a private customer. Fortunately, progressive-minded money transfer companies now offer this product to their customers.

Australia-based OFX, and the UK’s Currencies Direct and WorldFirst all offer forward contracts to their customers . You won’t be able to move your money to complete your deal until later in 2019. However, with the Brexit deadline threatening to tank rates, a forward contract will give you the chance to lock in a favourable one now.

Note that some companies require a minimum sum before you can use this service. For instance, OFX has a threshold of $30,000, while WorldFirst’s is only £1,000. If you meet these requirements, you’ll then be asked to set the contract length. OFX offers terms spanning two days to twelve months, allowing you to get a great rate even if your closing date is many months in the distance.

There is one risk which we must discuss, though. If currency rates move against expectations, you may need to pay extra to maintain the transfer. Read the fine print of any forward contract before confirming it to avoid nasty surprises and be sure to find a provider that works specifically in Spain.     

Set it and forget it: guarantee yourself a great exchange rate

Don’t let geopolitical theatre stop you from pursuing your dreams. Investors have used tools like forward contracts to protect themselves from black swan events for years. Now, they are available to small business owners and everyday people like you.

By hedging against disastrous currency fluctuations, you can carry on with your life without worry. Given the state of the world, who wouldn’t pay for a little peace of mind these days?