CIMA BA1 Syllabus D. The Financial Context Of Business - Currency Forward - Notes ^{5 / 8}

Forward contracts are typically signed between a business and bank.

They are a binding contract.

So we have agreed a sale now in a foreign currency, but the cash won’t be paid (or received) until a future date

With a forward rate we are simply agreeing a future rate now.

Therefore fixing yourself in against any possible future losses caused by movements in the real exchange rate

However - you also lose out if the actual exchange rate moves in your favour as you have fixed yourself in at a forward rate already

Illustration

A UK Company has to pay $100m in 3 months. 

So you enter into a forward agreement to exchange £90 using exchange rate £:$0.90 in 3 months.

Like that you dont need to worry about the movement in the exchange rates.

• So, in 3 months time you'll have:
  £90 / 0.9 =  $100

Advantages of forward rate

1. Flexible

2. Straightforward

3. By fixing the rate, forward contracts remove risk, and they are cheap (normally free) to arrange.

Disadvantages of forward rate

1. Contracted commitment (even if you haven’t received money)

2. Cannot benefit from favourable movements

3. The bank is unlikely to offer an attractive interest or exchange forward rate, because it is looking to make a profit on the transaction.

4. The forward contract is for a fixed date, so a company needs to be certain about the timing of transactions before entering into a forward contract.