In the foreign exchange market, a forward contract is an agreement that gives you today’s exchange rate on established settlement date in the future. These contracts are a simple, yet highly effective and important financial instrument for offsetting currency risk.
A forward contract effectively “locks in” today’s exchange rate, plus or minus the forward points, for a future payment.
Although forward contracts protect you against the risk that an exchange rate could move against you, they also prevent you from taking advantage of any positive movements. However, it is more important to play it safe and protect your company’s liquidity, which can be threatened by currency market volatility.
For example, if a company based in the Eurozone orders supplies from a company in the United States the current exchange rate would mean they have to pay €100,000 for their order. However, a forward contract can set the exchange rate at a lower rate, meaning that it will cost the company US$100,000 (€87,000), to pay 60 days from now.
Alternatively, the company may not be in a position to pay until the due date. Rather than expose their bottom line to the risk of severe currency fluctuations against them, the company decides to hedge by purchasing a forward contract to secure today’s rate, thus securing their liquidity.