Forward contract

What it means

A forward contract is an agreement between a company and a bank to buy or sell a set amount of foreign currency or a commodity on a future date at a rate agreed today. No money changes hands when it is signed; the exchange takes place on the settlement date at the pre-agreed rate, whatever the market rate is then.

The forward rate is not a forecast of the future rate. It is today’s rate adjusted for the difference in interest rates between the two currencies over the period. If the foreign currency has higher interest rates than the euro, the forward rate is less favourable for a seller than today’s rate, and vice versa.

A forward is the simplest derivative for hedging currency risk. Unlike an option it binds both parties: the company is protected against an adverse move in the rate but cannot benefit from a favourable one. Where the payment date is uncertain, flexible forwards with a window for the exchange are used.

How it works in practice

A typical user is a Slovak exporter that invoices in dollars and is paid in three months. With a forward it fixes today how many euros it will receive and can calculate its margin precisely. An importer paying in foreign currency does the opposite. We recommend hedging amounts that are certain, for example based on signed contracts.

In the accounts a forward is not recognised on the balance sheet when entered into but is kept in off-balance-sheet records. At the reporting date it is measured at the fair value reported by the bank, and the change is booked depending on whether it is a hedge. On settlement the difference between the forward and the current rate is recorded.

Banks usually require a framework agreement and a limit for forwards, and sometimes collateral, because a large rate movement exposes them to the risk of the company not performing. Smaller companies can also hedge more simply, for instance by invoicing in euros or matching income and costs in the same currency.

What to watch out for

The most common mistake is hedging an amount that later does not materialise. If the customer cancels, the forward still stands and the company must buy or sell the currency at the agreed rate, which may mean a loss. Hedges should match certain, not merely expected, flows.

The second mistake is treating a forward as speculation and judging it by whether it “beat” the market. The point of hedging is certainty, not profit. If the rate moved favourably and the forward shows a loss, the hedged transaction gained at the same time, and together they deliver the agreed result.