Buying Forward Foreign Exchange

Importing or exporting usually means foreign exchange transactions. Buying currencies forward will prevent exchange rate losses.

Spot Currency

Take for example a UK company planning to import merchandise which is priced in US Dollars. The exchange rate at the time of placing the order i.e. "spot rate" is US$1.60 / £1.00 and the merchandise is priced to return a gross profit margin of 40%. If payment is by cash with order, that exchange rate and therefore the planned profit margin will apply.

Foreign Exchange Risk

If however payment is deferred and the US$ / UK£ rate of exchange falls to US$1.50 by the time payment is due your planned cost of goods will be increased by six percentage points. Reduced profits arising from this come straight off your bottom line; liquidity and cash flow.

Whether importing or exporting, your bank can enable the business to protect its gross profit margin from foreign exchange losses by way of forward currency purchases.

Foreign Exchange and Letters of Credit

Buying by letter of credit often represents a prepaid transaction to many small and medium sized enterprises (SMEs) as its value will be charged to the bank account on the day it is issued. This does not however automatically protect a business from exchange rate fluctuations unless payment is defined in your local currency. If that is not the case you will still need to make a forward currency purchase to avoid potential foreign exchange losses.

Ordering Foreign Exchange

Any recognised international currency can be purchased forward: If you instruct the bank to buy dollars forward to cover the above example on the due payment date or dates,  $1.60 will be the applicable rate on the day. Note however on the day.
 
A forward currency purchase is a contract between you and the bank and calls for careful planning. The date you set for the delivery of the dollars at a fixed rate of exchange of $1.60 in this example is specific:  If payment is not made on the day the dollars can be held in the account but you cannot call them in ahead of that date.
 
Your business plan does not necessarily require the forward currency purchase to be enacted on the day the import order is placed. Purchasing orders for foreign exchange at fixed rates of exchange can be enacted at any time before payment is due. This applies to all transactions, whether by open credit, bills of exchange or letters of credit.

Planning Forward Foreign Exchange Purchases

You do not have to apply forward currency purchases piecemeal either. For example if you know that you will be expected to pay out $20,000 in a month’s time and another $15,000 in the following month you can choose to order the dollars for this en bloc at fixed rates of exchange, to be delivered in packets on dates that you specify. Such foreign exchange arrangements can be made for up to twelve months ahead.

Fixed rates for forward foreign exchange purchases for one month ahead will probably differ slightly from those for two or three months ahead and so on up to a year. It is always advisable when calculating landed cost prices to base business planning for profits and cash flow on the least favourable rate.  

Forward Foreign Exchange Purchases and Cash Flow

The one cash flow implication when ordering foreign currency at fixed rates of exchange is that the bank may wish to take a deposit from the business account at the time the order is placed; usually 10% to enable them to hedge their own risk.
 
This would be a deposit though, not a charge: If the dollar in our example were to become more expensive against your local currency by the time payment falls due, that would be the bank’s problem not yours.

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