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Forward contracts: Definition and frequently asked questions
Forward contracts offer protection against fluctuating exchange rates when you need to send an international money transfer.
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When you need to send money overseas, the exchange rate you receive is a crucial factor in determining the overall cost-effectiveness of your international money transfer. The value of the Australian Dollar relative to other currencies around the world changes all the time and is influenced by a range of factors. This, in turn has an impact on how much of the money you send arrives to your beneficiary.
You can protect yourself against fluctuating exchange rates by placing a forward contract, which allows you to secure the current exchange rate for use in a future international money transfer.
Trading CFDs and forex on leverage is high-risk and you could lose more than your initial investment. It may not be suitable for every investor. Refer to the provider’s PDS and consider the risks before trading.
Disclaimer: Exchange rates change often. Confirm the total cost with the provider before transferring money.
Important: Share trading can be financially risky and the value of your investment can go down as well as up. “Standard brokerage” fee is the cost to trade $1,000 or less of ASX-listed shares and ETFs without any qualifications or special eligibility. If ASX shares aren’t available, the fee shown is for US shares. Where both CHESS sponsored and custodian shares are offered, we display the cheapest option.
What are forward contracts?
Forward contracts are an international money transfer tool that allow you to reduce your exchange rate risk. When you place a forward contract you can lock in the current exchange rate for an overseas money transfer that will take place at a later date.
Securing a rate in advance allows you to plan ahead and safeguard your finances against any potential future drops in the value of the Australian Dollar. If you expect the value of the currency you are planning on sending to fall, you can consider placing a forward contract and ensure that you get better value for money on your transfer.
Back to topHow do forward contracts work?
Forward contracts let you enjoy the benefits of a good exchange rate today on a transaction that will take place up to 12 months into the future. To calculate the rate for your forward contract, a money transfer provider will adjust the spot rate (the current market exchange rate) for what are known as ‘forward points’, which factor in the difference in interest rates between your sending and receiving countries and the length of time until your transfer will actually be completed. A standard formula is used across the industry when calculating forward point.
You will usually be required to pay a deposit to secure your exchange rate but will then be able to enjoy protection against any exchange rate fluctuations that may occur until your transfer is placed.
For example, Brian knows that he will need to send a transfer of AUD $5,000 to the United States in two months’ time to pay off an outstanding debt to his brother. The current exchange rate is 1 AUD = 0.70 USD, but financial experts and economists are predicting the value of the Aussie Dollar to drop further in the coming weeks.
Brian doesn’t have all the funds needed to transfer the full amount now, so he places a forward contract with an online money transfer provider and locks in the current exchange rate. He pays a 10% deposit of $500 and, two months later, pays the remaining $4,500 and his transfer is sent. Brian’s brother receives USD $3,500 two days later.
Had Brian not placed a forward contract and simply transferred the money using the best exchange rate he could find, he would have had to settle for an exchange rate of 1 AUD = 0.67 USD. This means his brother would only have received $3,350 - $150 less than he received thanks to Brian’s forward thinking.
What types of forward contracts are there?
Although this article only deals with forward contracts in terms of international money transfers, forward contracts can also be used as a trading tool across a range of other financial assets. These include shares, contracts for difference, commodities and more.
How do I compare forward contracts?
- Exchange rates. Although forward points are calculated using an industry standard formula, the spot exchange rate on offer will differ from one company to the next. See which transfer companies regularly offer exchange rates that compare favourably to the competition.
- Fees. Will you need to pay an extra fee to lock in a forward contract? If so, how much? And will you need to pay this on top of the standard transfer fee that a company already charges?
- Transfer options. Consider the options available for placing a forward contract, such as online, over the phone, or by using a mobile app.
- Customer support. If you ever have a question about a transaction, will you be able to get the help you need from your transfer provider?
What are the pros and cons of forward contracts?
Pros
- Protect yourself. Forward contracts allow you to protect your finances against the impact of fluctuating exchange rates.
- Buy now, pay later. You don’t have to pay for the full cost of your transfer until it is actually placed, which could be up to 12 months into the future.
- Choose a rate that suits you. Forward contracts give you the power and freedom to secure an exchange rate that suits your financial needs.
Cons
- The exchange rate could improve. Predicting the future value of a currency can be difficult, so there is a risk that the exchange rate will rise in the interim and cost you money.
What are some of the risks?
The main issue to be wary of with forward contracts is that the exchange rate could rise after you lock in a forward contract and you could end up losing out. A huge range of factors can affect the value of one currency relative to another, and sometimes it’s not possible to predict exactly which way the value of a currency will go.
Frequently asked questions
Disclaimer: This information should not be interpreted as an endorsement of futures, stocks, ETFs, CFDs, options or any specific provider, service or offering. It should not be relied upon as investment advice or construed as providing recommendations of any kind. Futures, stocks, ETFs and options trading involves substantial risk of loss and therefore are not appropriate for all investors. Trading CFDs and forex on leverage comes with a higher risk of losing money rapidly. Past performance is not an indication of future results. Consider your own circumstances, and obtain your own advice, before making any trades.
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