Any business transaction that is settled in a foreign currency presents the risk of loss due to exchange risk. This risk occurs when, for example, a customer is contractually required to pay you in a foreign currency at some point in the future, and the value of the currency increases before it is paid, so that the currency converts into fewer units of your own currency. In short, you record a loss on the currency exchange. The same problem arises when you are obliged to pay a supplier on a future date; thus, there is currency exchange risk for both buying and selling transactions.
A reasonable approach for mitigating this risk is to purchase a forward contract. By doing so, a company locks in an exchange rate today for the delivery of a payable or receivable as of some future date. This enables a company to eliminate currency exchange risk, so that it can ascertain exactly how much profit it will earn on a transaction that will be settled in the future.
The basic transaction is to enter into a fixed term forward contract, whereby you agree to purchase a fixed amount of a foreign currency on a specific date, and at a pre-determined rate. A deposit is usually required to secure the contract, with a final payment due in time to be cleared by the settlement date of the contract. The price of the contract is based on the current exchange rate, plus a transaction fee, plus the interest rate differential between the two currencies. The currency forward contract is considered to be an over-the-counter transaction, because there is no centralized trading location, and transactions are created directly between parties.
There are a few problems with currency forward contracts to be aware of. First, contracts may only be available for settlement in sizes that do not match the exact amount of the underlying business transactions. Also, the settlement date may not precisely match the required date. Further, because they are special transactions between two parties, it can be difficult to sell them to a third party. Finally, the exchange and/or transaction premium offered may not be competitive.
Forward contracts are readily available in the major currencies (e.g., the U.S. Dollar, British Pound, Euro, Swiss Franc, and Yen). Contracts can also be obtained in other currencies, such as the Mexican Peso, Swedish Krona, and South African Rand.
Many banks can purchase forward contracts on behalf of a company; smaller banks will outsource this service to a large regional or international bank. In addition, there are a number of specialist firms that deal exclusively with foreign exchange transactions, and which offer competitive rates. Examples of such firms are Commonwealth Foreign Exchange, Custom House, and Easy Forex.