Why are currency forwards needed?

Question

Commonly, a currency forward is said to be useful when one has to make a payment in another currency in a future date, e.g. a European company has to pay 1 million USD exactly one year from now. It is often claimed that the company can protect from currency risk by entering into a forward contract, whereby the company agrees to exchange a certain amount of euros to exactly 1 million USD exactly one year from now.

What is the point of this? Can't I achieve the exact same effect and outcome by exchanging currency now and put that amount of USD in a bank account to gain some interest, then make the payment from one year from now?

Answer 1

Can't I achieve the exact same effect and outcome by exchanging currency now and put that amount of USD in a bank account to gain some interest, then make the payment from one year from now?

Sure, assuming that the company has the money now. More commonly they don't have that cash now, but will earn it over the time period (presumably in Euros) and will make the large payment at some point in time. Using a forward protects them from fluctuations in the exchange rate between now and then; otherwise they'd have to stow away USD over the year (which still exposes them to exchange rate fluctuations).

Answer 2

Suppose you're a European Company, selling say a software product to a US company. As much as you might want the US company to pay you in Euros they might insist (or you'll lose the contract) that you agree pricing in USD. The software is licensed on a yearly recurring amount, say 100K USD per year payable on the 1st January every year.

In this example, you know that on the 1st Jan that 100K USD will arrive in your USD bank account. You will want to convert that to Euros and to remove uncertainty from your business you might take out an FX Forward today to remove your currency risk.

If in the next 9 months the dollar strengthens against the Euro then notionally you'll have lost out by taking out the forward. Similarly, you've notionally gained if the USD weakens against the EURO.

The forward gives you the certainty you need to plan your business.

Answer 3

What is the point of this? Can't I achieve the exact same effect and outcome by exchanging currency now and put that amount of USD in a bank account to gain some interest, then make the payment from one year from now?

This is for companies, not individuals. Companies usually take loans, because they think they can make more money (e.g. 10%*) than the interest on the loan (e.g. 5%*). Putting money on a bank account to earn interest there would give them even less (e.g. 1%*). So with your option, instead of earning 10%* interest, they'd earn 1%* interest.

If the cost of the currency forward is less than these 9%* difference, the forward saves them money.

If they have excess cash and they don't know how to invest that money, your option may be preferable

*Simple numbers chosen for simplicity, not accuracy.

Answer 4

e.g. a European company has to pay 1 million USD exactly one year from now

While that is theoretically possible, that is not a very common case. Mostly likely if they had to make a 1 million USD payment a year from now and they had the cash on hand they would be able to just make the payment today.

A more common scenario for currency forwards is for investment hedging.

Say that European company wants to buy into a mutual fund of some sort, say FUSEX. That is a USD based mutual fund. You can't buy into it directly with Euros. So if the company wants to buy into the fund they would need to convert their Euros to to USD.

But now they have an extra risk parameter. They are not just exposed to the fluctuations of the fund, they are also exposed to the fluctuations of the currency market. Perhaps that fund will make a killing, but the exchange rate will tank and they will lose all their gains. By creating a forward to hedge their currency exposure risk they do not face this risk (flip side: if the exchange rate rises in a favorable rate they also don't get that benefit, unless they use an FX Option, but that is generally more expensive and complicated).

Answer 5

To speak to this a little more broadly: apart from groups like hedge funds and other investors investing for purely speculative purposes, one of the major purposes of forwards (and, for that matter, futures) for companies in the "real economy" is to "lock in" a particular price in advance (or to reduce the risk of some kind of investment or transaction).

Investopedia defines a currency forward as follows (with a few key points emphasized):

[A currency forward is] a binding contract in the foreign exchange market that locks in the exchange rate for the purchase or sale of a currency on a future date. A currency forward is essentially a hedging tool that does not involve any upfront payment. The other major benefit of a currency forward is that it can be tailored to a particular amount and delivery period, unlike standardized currency futures.

This can be a major advantage for planning and risk management purposes. For example, if I know I'm going to have to pay $1 million USD in the future and most of my revenue is in Euros, the actual amount I'll have to pay will vary based on the exchange rate between Euros and dollars. Thus, it's very worthwhile for me to be able to "lock in" a particular exchange rate so that I know exactly how much I'm going to pay relative to my projected revenue. The goal isn't necessarily to make money off the transaction (maybe they do, maybe they don't) as much as to reduce risk and improve planning ability.

The fact that it doesn't involve an up-front payment is also a major advantage. It's usually a bad practice to "sit on" cash for a year if you can avoid it.

Another key point: savings accounts pay less interest than inflation. If inflation is 3% and your savings account pays 1%, that looks remarkably like a guaranteed 2% loss to me.