Forward Exchange Contract
Forward Exchange Contract is a contract between two parties, where one agrees to deliver a certain amount of foreign exchange at an agreed rate at a fixed future date to the other party.
Forward Exchange Contracts are used to hedge against the adverse movement in exchange rate.
Example
On 01/Aug/2028, a European firm exported a machinery to a USA Firm for 1,00,000 $ on a 3 months credit basis.
On 01/Aug/2020, exchange rate was 1$=0.8000 Euro.
At the end of credit period ( 31/Oct/2020 )
Spot exchange rate is
(I) 1$=0.7800Euro, in this case European firm will loose 0.0200 Euro/$, therefore Loss on foreign exchange will be 2,000 Euro (0.0200X1,00,000).
(ii) 1$=0.8100Euro, in this case firm will gain 0.01 Euro/$, therefore Gain on foreign exchange will be 1,000 Euro (0.0100X1,00,000).
Use of Forward Contract
To limit exchange loss, European firm can use Forward Contract.
Suppose the firm enters into a Forward Contract to sell 1,00,000$ @ 1$=0.7950Euro, then at the end of 3 months credit period (31/Oct/2020), whatever be the exchange rate (higher or lower ) firm will receive @ 1$=0.7950Euro, therefore firm can limit it's loss to 0.0050 Euro/$. and Loss on foreign exchange will be limited to 500Euro.
Conclusion
Forward contract limits the expected Foreign Exchange loss, but doesn't give benefits of foreign exchange gains.
Thank you for reading.
