Forward Exchange Contract

From CEOpedia | Management online
Forward Exchange Contract
See also


Forward Exchange Contract - is a binding and immediate agreement between the customer and the bank for the purchase or sale of a certain amount of foreign currency at the exchange rate specified in the agreement[1]. This applies to the performance of activities (currency delivery and payment for it) in the future[2]. These are contracts that require special treatment[3].

A forward exchange contract may imply a discount or premium. Authors Carmichael D.R., Graham L. write that: "The discount or premium on a forward contract is the foreign currency amount of the contract multiplied by the difference between the contracted forward rate and the spot rate at the date of inception of the contract. Ordinarily, a discount or premium is allocated to income over the duration of the forward exchange contract."[4].

Advantages and disadvantages of forward exchange contract

Advantages of forward exchange contract[5]:

  • The amount can be any (theoretically).
  • Transaction costs are low.
  • Transactions of this type are not subject to the requirement of a trading exchange.
  • Transactions are over the counter.
  • Contracts have a flexible duration (however, they are usually concluded for less than two years).

Disadvantages of forward exchange contract[6]:

  • They are difficult to cancel (due to contractual obligations).
  • There is a risk in which the contractor defaults.
  • The organization may not be protected that trading on an exchange brings.

Fixed and option contracts

Fixed means that the contract has a specific date on which it will be performed. For example, a 3-month contract concluded on 1 May will have to be executed on 1 August. However, option means that performance may take place at the discretion of the customer: on any day from the moment the contract was signed up to the date of the final date or in any period limited by dates[7].

Footnotes

  1. BPP Learning Media 2015
  2. BPP Learning Media 2015
  3. Carmichael D.R. , Graham L. 2012
  4. Carmichael D.R. , Graham L. 2012
  5. BPP Learning Media 2015
  6. BPP Learning Media 2015
  7. BPP Learning Media 2015

References

Author: Justyna Siudy