Hedging foreign exchange risks with a forward foreign exchange transaction

A forward foreign exchange agreement is an agreement between 2 parties concluded over the counter, the purpose of which is to cover a business against the risk of unfavourable exchange rate fluctuations between 2 currencies.

This is a so-called 'simple' hedging instrument, thanks to which the business can set in advance the exchange rate at which it may buy or sell a certain amount of foreign currency at a specific future date.

Who is concerned

A forward foreign exchange transaction applies to the self-employed and any type of business seeking to limit the foreign exchange risk affecting its international transactions in foreign currencies, such as:

  • exports of goods (raw materials, semi-finished products, merchandise) and services to customers who pay in a currency other than the euro;
  • imports of goods and services from suppliers that do not accept the euro as a means of payment;
  • purchase of production equipment from a foreign supplier that wants to be paid in a currency other than the euro.

European exporters will hedge themselves against the risk of depreciation of the foreign currency (strengthening of the euro) in which the invoice will be paid by selling a forward foreign exchange agreement. In this way, they set the amount (in euro) that they will receive in exchange for the foreign currency.

European importers will hedge themselves against the risk of an increase in the foreign currency (depreciation of the euro) in which the invoice will be paid by buying a forward foreign exchange agreement. In this way, they set the amount (in euro) that they will have to change into foreign currency to settle the invoice.

Prerequisites

Presentation of the application

Explanation of the underlying financial transactions to the bank.

Guarantees

Some foreign exchange hedging transactions represent a credit risk for banks, causing them to analyse the applicant business and submit the application to the credit committee. It is not, however, customary for the bank to request tangible guarantees for this type of transaction.

How to proceed

Application

Amount

A minimum amount to be able to access forward foreign exchange transactions is generally required and varies depending on the bank.

Duration

  • short-term;
  • duration varies between a few days and 12 months, although a period exceeding 12 months is possible.

Exchange rate

The exchange rate set by the 2 parties is called a forward rate; it is a rate set today for a transaction that will be carried out in the future. The forward rate depends on various factors, namely:

  • the spot rate – this is the exchange rate currently in force;
  • the interest rates of the 2 currencies;
  • the duration of the contract.

The forward rate is either higher (contango) or lower (backwardation) than the spot rate. Contango/backwardation is determined by the difference between the interest rates of the 2 currencies for the period in question:

  • contango = interest rate of one foreign currency higher than the euro with a forward rate of the euro higher than that of the spot rate;
  • backwardation = interest rate of one foreign currency lower than the euro with a forward rate of the euro lower than that of the spot rate.

Payment of a balancing amount or differential

At maturity, the market exchange rate of the day is compared to the agreed rate:

  • if the euro has strengthened against the foreign currency and is higher than the agreed rate, it is the buyer (importer) of the forward foreign exchange agreement that has to pay the seller (exporter) an amount equal to the difference between the 2 rates.
  • if the euro has depreciated against the foreign currency and is lower than the agreed rate, it is the seller (exporter) of the forward foreign exchange agreement that has to pay the buyer (importer) an amount equal to the difference between the 2 rates.

An exchange of the notional amounts is possible, but this is rarely done.

Set-up times

The reviewing and processing times depend on the complexity, size and urgency of the case.

Advantages, disadvantages and risks

Advantages

  • importing (exporting) businesses are protected against an excessive depreciation (strengthening) of their local currency by a guaranteed minimum (maximum) rate;
  • possibility of reversing the transaction at any time given that it is a very liquid market;
  • makes budgeting easier as the minimum (maximum) amounts to be received or paid are known;
  • easy to manage, recorded off-balance sheet for the business.

Disadvantages

  • no possibility of benefiting from a favourable exchange rate fluctuation between the determination date and the settlement date (due date);
  • difficult to synchronise between the foreign exchange transaction and the forward foreign exchange rate if the payment date is not known from the beginning.

Risks

Credit risk (because an over-the-counter agreement involves the risk of counterparty default).

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