Understanding corporate finance: derivative contracts: forward contracts
At its simplest, a forward contract is an agreement to buy or sell
- a given quantity of a particular asset
- at a specified future date,
- at a pre-agreed price.
For example, a frozen food manufacturer might contract with a vegetable grower to buy a given number of tonnes of peas (of a specified quality) at a given price, delivery to be made directly after harvest. This type of agreement, in relation to commodities, has been used for centuries to protect both buyer and seller from the risks of movement in prices.
Today, the most prevalent use of forward contracts is in the currency and interest rate markets.
It is very common for companies exposed to foreign exchange risks to hedge those risks by entering into a forward foreign exchange contract, normally with a bank. A forward foreign exchange contract (sometimes just called a currency forward) is a legally binding agreement to buy, or sell, an agreed amount of one currency for an agreed price payable in another currency, on a specified future date.
Blujak Ltd has borrowed €500,000 to finance the launch of a new product in France. The loan is repayable in 12 months’ time. When the loan is taken out, the exchange rate is 1 euro = £0.6150, so that €500,000 is worth £307,500. When the company comes to repay the loan, it might have to repay more than £307,500 if the pound has weakened against the euro, so that it suffers a loss. Alternatively, if the pound strengthens, it may make a profit.
The company is willing to forego any windfall profit, provided it can guarantee that it will not make an unexpected loss. Blujak Ltd therefore arranges with its bank to buy €500,000 in 12 months’ time. The bank quotes a one year forward rate of 1 euro = £0.6200, so that the company will have to pay £310,000 for the euros. The company will have made an exchange loss of £2,500, but it now knows about this in advance and can budget for it.