Managing your exposure to currency risk

If you’re transferring money internationally, you’ll want to ensure you’re making the most of your money. Whether you’re sending money abroad for family and friends, or investing offshore, you may wish to manage your exposure to currency risk and protect your funds from unwanted exchange rate movements.

Understanding how currency hedging works, starts with some basic questions. While there are many foreign exchange solutions available to help you minimise risk and maximise savings, forward contracts may be the solution most worth your time.

What is a Forward Exchange Contract and how do you enter one? Let’s explore.

What is a Forward Contract?

Put simply, FX Forwards are contracts which establish an agreement to exchange a specified amount of currency at a pre-determined future date. The price you lock in is determined on the day you agree the amount and settlement date for the forward contract. The reason an FX forward contract is so beneficial for cross border payments is because with larger sums of money, even a one per cent fluctuation of the exchange rate can have a significant impact on what you pay. 

The ability to set an exchange rate in advance is an excellent way to secure a guaranteed currency amount regardless of what happens in currency markets between the transaction agreement date and the settlement date.

How are FX Forwards priced?

There are some lovely technical formulas which we will not bore you with in this article, in the interest of everyone’s sanity. Instead, here are the key takeaways regarding FX Forwards pricing.

The forward exchange rate is worked out using the spot price – the market exchange rate at the time the contract is agreed – and the “interest rate differential” over the term of the contract. The interest rate differential is the difference in interest rate between two currencies.

For example, if the South African Reserve Bank sets the interest rate at 5% while the US Federal Reserve bank sets the interest at 2%, the interest rate differential between the ZAR and USD is 3%. The reason the interest differential influences the forward exchange rate is that interest rate changes influence currency exchange rates (and are used by governments’ central banks to precisely do this). 

How does a forward transaction differ from a spot market transaction?

The main difference is that the spot market transaction operates with immediate delivery. However, FX Forward transactions agree on delivery at a future date and as such carries different pricing to the spot market. 

There is a common misconception among those first encountering these contracts that FX Forwards denote the price at which a currency pair is expected to be trading in the future. However, this is not the case. FX Forwards are merely a function of the relevant interest rates and the duration of the contract and in no way reflect any expectations of where the price is headed. 

A quick example:

1. Maya is buying property abroad. In December, when she made her offer, the sterling pound was trading at R19.00/£ but just three months later, the exchange rate jumped to R19.80/£.  It may not sound like much, but it meant her £400,000.00 property would have cost her an additional R320,000.00. 
2. Luckily, Maya spoke to her dedicated Currency Partners FX Dealer, and they discussed the current spot rate for an exchange and possible forward rates, as well as examining the potential to split the exchange between the two. 
3. With the current 3-month FX forward rate at 19.50/£ in December, Maya locked in the exchange rate for settlement the end of March, which meant she knew what her costs would be and was able to budget accordingly for her property purchase without worrying about currency fluctuations. To secure the forward rate, she simply paid a small deposit of 10% to secure the forward exchange rate.
4. Three months later at the agreed settlement date, Maya transferred the 90% Rand balance to Currency Partners and her sterling pounds were paid out to the offshore beneficiary account within two working days.