Settlement

A spot deal will settle (in other words the physical exchange of currencies will take place) two working days after the deal is struck. This 'value date' reflects both the need to arrange the transfer of funds and, in most cases, the time difference between the currency centres involved, one or other of which may well be closed at the time of the trade.

Summary

Forecasting exchange rates is very difficult – you cannot know for certain what the exchange rate is likely to be by the end of today, let alone a few months. A company using only the spot market for its foreign currency requirements is using the simplest method, but at the same time the most risky. If you placed an order for raw materials from Italy for payment in three months, and use the spot market to meet the invoice when it falls due, your company could lose significantly if rates move against you over that three month period.

Forward Exchange Contracts

A forward exchange contract (or forward contract) is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on or before a certain date. Contracts can be taken out for completion on an agreed date or at any point between two pre-agreed dates (up to three months apart). To take out a forward contract you need to advise us of the amount, both currencies involved, the expiry date and whether you would like to buy or sell the currency on the expiry date or anytime during a pre-agreed period.

Purpose

A forward contract is the simplest method of covering exchange risk, without having to worry whether the spot market is going to move against you. This overcomes one of the problems that you can experience when importing or exporting in foreign currency, as you can now budget at a guaranteed rate of exchange.

Pricing

The price of a forward contract is based on the spot rate at the time the deal is booked, with an adjustment that represents the interest rate differential between the two currencies concerned. For example, you need to buy US dollars in three months. Say US interest rates are higher than EUR interest rates. The pricing principle assumes that HSBC buys US dollars now, paying for the dollars with euro, in order to meet our obligation to you under the contract in three months time.

We pass on to you the benefit of the higher rate of interest we earn on the dollars. The adjustment to the spot rate means that the forward contract rate would be more favourable than a spot deal rate. The reverse would apply if US interest rates were lower than EUR rates.

Summary

• A forward contract protects your company against adverse movements in exchange rates.
• You can be sure of meeting a budget rate for the transaction.
• A forward contract is an obligation. Even if your requirements change over the term of the forward contract, you are still obliged to deal.
• A forward contract obliges you to deal at a specific rate – you are not in a position to benefit from any favourable movements in exchange rates between booking the contract and completing the deal.