Updated: Apr 19
A forward contract is a modifiable contract made between two parties, whose purpose is to buy or sell an underlying asset at a specific price, at a specific date. Forward contracts are often used for financial hedging purposes, or as a tool to generate income through speculation. Their non-standardized nature makes them an excellent tool for strategies in risk management.
These contracts, by nature, are considered over-the-counter (OTC) instruments, which means that they can be custom made to the client’s needs with ease. The forward contract market is huge and most multinational companies use these contracts to hedge FX, commodities and interest rate risk.
The primary risk in doing financial hedges with forward contracts, unlike options, is that once the contract is made, it must be fulfilled. This can cause financial losses if the underlying asset’s spot price moves favorably with the contract holder’s needs, but the contract holder is tied down to a specific price.
USD/MXN Forward Contracts
Given the amount of business between the USA and Mexico, there is a constant flow of currencies. The volatility in the exchange rate often leads companies into hedging their rate with the use of forward contracts, consequentially guaranteeing a stable rate.
If a company in the US knows that it must pay their suppliers $1,000,000 Mexican Pesos (MXN) each month, in several payments, they can use a forward contract to fix the exchange rate to something that is favorable for the company. If, at the beginning of the month, the USD/MXN rate is high, the company can fix it, so they can take advantage of it throughout the month. The company will receive said exchange rate all through the month, disregarding any movements in the rate. In this case, the company would rather have a high exchange rate, for it will get more pesos per dollar when it pays its suppliers.
Price of a Forward Contract
The mechanism to calculate the price of a forward contract for two currencies is dictated by the parity relationship between the spot exchange rate and the differences in the respective interest rates. In the case of the US and Mexico, the US has the Federal Reserve Interest Rate, and Mexico has the Tasa de Interés Interbancaria de Equilibrio (TIIE).
With this formula, you can calculate the future value of any currency, and it is used whenever a person, or a company, wants to utilize forward contracts.
A Mexican company receives an average of $100,000 USD in payments every month. Said company sells the dollars they receive to finance their expenses. They usually sell around $25,000 dollars every week. Using a month as an example, you can observe the differences between two situations, one in which the company utilizes forward contracts, and one in which they do not use financial instruments.
Once the difference is subtracted within the profit and loss, the company has a positive overturn of $8,750 MXN. This is the main goal of financial hedges, guaranteeing protection against adverse movements in the exchange rate.
One can see that there are some weeks in which the forward contract did not help the company save money, given that the exchange rate went up, and that resulted in losses. But these are not losses, just additional income which was not obtained. When a person or company uses a forward contract, they agree on the exchange rate, and must fulfill that obligation.
Whilst this is a hypothetical case study, the reason why most multinational companies use forward contracts, is to guarantee a certain exchange rate. This not only helps them plan their finances, but it also gives the holder of the contract the certainty and security of knowing that they are protected against any adverse movement in the exchange rate.
Companies often use this to create an advanced planning of their use of foreign currencies without risk and consequently create more complex strategies.