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Forward contract against export: Meaning, types, and more

A forward contract lets importers and exporters swap currencies at a set rate for a specified amount. Learn more about its uses and advantages in this blog.

All commodities, whether crude oil or consumables, go through price fluctuations. The prices of these commodities can vary widely, and this uncertainty can impact businesses and their operations. Many businesses use a financial derivative known as a forward contract agreement to avoid or mitigate these risks.

What is a forward contract against export?

A forward exchange contract is a financial agreement between an importer and an exporter that allows them to exchange a specified amount of the importer’s currency for the exporter’s currency at a predetermined exchange rate. This exchange is made on the date when the payment for export is due, using existing currency exchange rate when the contract for sale is made. By entering into a forward exchange contract, both parties can protect themselves from any financial loss resulting due to changes in exchange rate. A forward contract specifies the sales price in the form of how much of the importer's currency is needed to satisfy the final sales price with the exporter’s currency.

Forward exchange contracts are typically created by the exporter’s financial institution and play a crucial role in facilitating provides essential services such as foreign currency exchange, export financing, and risk management solutions to importers and exporters¹.

What are forward contracts used for?

Forward contracts are used for various purposes, including²:

For hedging investments:

One of the most common uses of forward contracts is for hedging investments. When a company invests in a product that is subject to price volatility, it can use these contracts to lock in a predetermined price for a future date.

Using open forward contracts:

Open forward contracts, also known as flexible contracts, allow parties involved to change contract terms during the contract period. This type of contract is ideal when there is uncertainty about the the delivery date or the quantity of a commodity that might be needed.

With market orders:

When using these contracts with market orders, parties involved agree to buy or sell the commodity at a future date at the best available market price.

Features of a forward contract

Here are some of the essential features of these contracts:

Non-standardized

Unlike futures contracts, these are not regulated by any third-party authority. The terms and conditions depend solely on the agreement between the two partie

Not regulated

These contracts are not standardized, which means that each contract is customized according to the needs and requirements of both parties.

Bilateral

This contract is a bilateral agreement between two parties, which means that both parties have to fulfil their obligations on the date of maturity.

Tailor-made

Since each contract is unique, parties involved can tailor the terms and conditions of the contract according to their specific needs.

No public disclosure

The price of these contracts is not publicly available, making it difficult for other market participants to know the price at which the contract was signed.

Settlement on maturity

Unlike futures contracts, which are marked-to-market daily, these contracts are settled on maturity.

No margin requirement

These contracts do not require any margin payment, so the parties involved do not have to deposit any upfront payment..

Types of forward contracts

Following are some of the common types of forward contracts³:

Closed outright forward

It involves two parties agreeing to exchange currencies at a particular future date by locking in an exchange rate.

Flexible forward

A flexible forward contract is an agreement between two parties to exchange currencies at a future date, just like a closed outright forward. However, it allows the parties to exchange funds before the settlement date, often in parts, as long as the entire amount is settled by the due date

Long-dated forward

In the long-dated contract, the settlement period extends over more than a year. Most of these contracts are short-term contracts, which is what differentiates long-dated contracts from the rest.

Non-deliverable forward

The non-deliverable forward is a type of forward contract that does not involve the physical exchange of a commodity, asset, or currency. Instead, the parties only exchange the difference between the contract and spot rates at maturity.

Advantages of a forward contract

Here are some advantages of forward contracts:

Customizable

Commodity forward contracts allow parties to agree on specific terms and conditions that meet their unique requirements like quantity, price, and delivery date.

Lower international trade-related risks

International trade carries many risks, including currency fluctuations, political risks, and legal or regulatory environment changes. Forward contract can help businesses mitigate these risks by providing certainty around the cost of exports.

No upfront hedging costs

Another advantage of commodity forward contracts is that they do not require any upfront costs for hedging. Unlike options, which require a premium payment, these contracts do not require businesses to pay anything upfront.

Disadvantages of forward contracts

Some of the main disadvantages are:

Non-regularized

One of the major risks or limitations of these contracts is that they are not standardized, and there is little public information available about the market cap. This lack of regulation can make it difficult for investors to assess these types of contracts’ risks.

Prone to counterparty risks

Since these contracts are bilateral agreements between two parties, there is always a risk that one party may default on their obligations.

Possible miscalculation of movement of prices

These contracts are useful for hedging against future price movements. However, they can also expose companies to risks and potential losses in a highly volatile market. If a company miscalculates the movement of prices, it may end up locked into an unfavorable contract and lose out on potential gains.

How are forward contracts calculated?

Here’s a step-by-step guide to calculating contracts:

Step 1: Determine the currency pair

Before calculating the forward contract, it is essential to determine the two currencies involved in the transaction.

Step 2: Determine the spot rate

The spot rate refers to the current exchange rate between the two currencies. The system adjusts the market spot rate when calculating the forward rate.

Step 3: Calculate the forward points

The forward points are usually determined by the difference between interest rates of these currencies in the pair and time to maturity of the contract.

Step 4: Add the forward points to the spot rate

Once you’ve determined the forward points, add them to the spot rate to calculate the forward rate.

Step 5: Agree on the total amount and exchange rate

After calculating the forward rate, agree on the total amount of the trade and the exchange rate.

Step 6: Agree on a binding contract

Once the currencies are paired, the total amount the business wishes to trade and the agreed exchange rate have been determined; a binding contract is automatically agreed upon.

Forward contracts are an effective tool to manage risks in commodity and currency trading. They provide businesses with price certainty, customization, and flexibility.

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Frequently Asked Questions

What is the difference between a forward contract and a futures contract?

A forward contract is a customized agreement that allows buying or selling an asset at a pre-decided price and date in the future. A futures contract is a standardized agreement traded on an exchange that obligates both parties to buy or sell the asset at a pre-decided price and a particular date in the future.

What is the difference between a forward contract and a spot contract?

A forward contract is made between two parties to buy or sell commodities at a pre-decided price and date in the future. On the other hand, a spot contract allows buying or selling an asset at its current market price and settling the transaction immediately.

Can forward contracts be cancelled??

The terms for cancellation are usually agreed upon when the contract is created. It’s important to carefully review the contract and understand the cancellation terms before deciding.

Are forward contracts regulated??

Financial authorities do not heavily regulate these contracts as they are privately negotiated agreements between two parties.

What is a forward contract in foreign exchange??

A forward contract in foreign exchange is made between two parties like an importer and exporter to purchase or sell a currency at an agreed-upon exchange rate and a future date.

Published on August 30, 2023.

Sources:
1. https://www.investopedia.com/ask/answers/061615/what-forward-contract-against-export.asp
2. https://corporatefinanceinstitute.com/resources/derivatives/forward-contract/
3. https://scripbox.com/pf/forward-contract/
4. https://efinancemanagement.com/derivatives/types-of-forward-contracts
5. https://wise.com/us/blog/what-is-a-forward-contract
6. https://groww.in/blog/how-do-forward-contracts-work
7. https://www.tradefinanceglobal.com/currency/forward-contracts/
8. https://www.investopedia.com/ask/answers/06/forwardsandfutures.asp
9. https://www.smartcurrencybusiness.com/services/spot-contracts/
10. https://www.dripcapital.com/en-in/resources/blog/what-is-a-forward-contract#15

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