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How can you manage foreign exchange risk with forwards contracts?

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If you are an investment banker, you may have to deal with foreign exchange risk, which is the possibility of losing money due to fluctuations in currency rates. One way to manage this risk is to use forwards contracts, which are agreements to buy or sell a certain amount of foreign currency at a fixed rate in the future. In this article, you will learn how forwards contracts can help you hedge your exposure to foreign exchange risk and what factors you need to consider when using them.

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Lock in future rates:

Use forwards contracts to fix an exchange rate for a future transaction. This shields you from volatility, ensuring your costs remain predictable regardless of market fluctuations.### *Tailor for M&A deals:Opt for Deal-Contingent forward contracts to hedge foreign acquisitions. This provides cost certainty and avoids significant losses if the deal falls through.

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Mark Battistoni

Founder, HedgeNX Group
Patrick Kunz, FRM QT

The Treasury Guru | Interim Treasurer…

1 What are forwards contracts?

A forwards contract is a type of derivative that allows you to lock in a specific exchange rate for a future transaction. For example, if you are advising a client who wants to acquire a foreign company, you can use a forwards contract to secure the amount of foreign currency you need to pay for the deal at a predetermined rate. This way, you can avoid the uncertainty and volatility of the spot market, where the exchange rate may change unfavorably before the transaction is completed.

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Patrick Kunz, FRM QT

The Treasury Guru | Interim Treasurer Network | FX | Risk & cash mngmnt | TMS & Fintech | Speaker & Moderator
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Bad example. A forward contract is a committed product, you have to settle it. A takeover is not certain so it might not happen. If it gets cancelled you still have to settle the forward (or sell it at a loss). A better wat to hedge takeovers is with FX options which are uncommitted. Match the hedging product with the exposure

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2 How do forwards contracts work?

To enter into a forwards contract, you need to find a counterparty who is willing to take the opposite position of your currency exposure. For example, if you want to buy euros and sell dollars in six months, you need to find someone who wants to sell euros and buy dollars in six months. You can use a broker, a bank, or an exchange to facilitate the trade. You and your counterparty will agree on the amount, the rate, and the maturity date of the contract. At the maturity date, you will exchange the currencies at the agreed rate, regardless of the spot rate at that time.

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3 What are the benefits of forwards contracts?

The main benefit of using forwards contracts is that they can reduce your foreign exchange risk by eliminating the uncertainty of future currency movements. For example, if you use a forwards contract to buy euros at 1.20 dollars per euro, you will know exactly how much dollars you need to pay for the euros, regardless of whether the spot rate goes up or down. This can help you plan your budget, protect your profit margin, and avoid losses from adverse exchange rate changes.

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4 What are the drawbacks of forwards contracts?

The main drawback of using forwards contracts is that they can limit your potential gains from favorable exchange rate changes. For example, if you use a forwards contract to buy euros at 1.20 dollars per euro, and the spot rate goes down to 1.10 dollars per euro, you will miss out on the opportunity to buy euros cheaper. Moreover, forwards contracts are not standardized and are subject to counterparty risk, which is the risk that your counterparty may default or fail to honor the contract. To mitigate this risk, you may have to pay a margin or collateral to secure the contract.

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Patrick Kunz, FRM QT

The Treasury Guru | Interim Treasurer Network | FX | Risk & cash mngmnt | TMS & Fintech | Speaker & Moderator
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Not all forwards Counterparties need collateralisation. This is agreed upon alon a bilateral basis. Collateral can work two ways.

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5 How do you price forwards contracts?

The price of a forwards contract is determined by the interest rate differential between the two currencies involved. The interest rate differential reflects the opportunity cost of holding one currency over another. For example, if the interest rate on dollars is higher than the interest rate on euros, it means that holding dollars is more attractive than holding euros, and therefore, the forward rate of dollars per euro will be lower than the spot rate. The formula for calculating the forward rate is: Forward rate = Spot rate x (1 + Interest rate of base currency) / (1 + Interest rate of quote currency)

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Patrick Kunz, FRM QT

The Treasury Guru | Interim Treasurer Network | FX | Risk & cash mngmnt | TMS & Fintech | Speaker & Moderator
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This is the theory indeed. In practise forward (points) can differ from the theoretical price due to market expectations or liquidity aspects

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6 How do you profit from forwards contracts?

To profit from forwards contracts, you need to anticipate the direction and magnitude of the exchange rate movements and enter into a contract that gives you a favorable rate compared to the spot rate at the maturity date. For example, if you expect the euro to appreciate against the dollar, you can use a forwards contract to buy euros at a lower rate than the spot rate in the future. Conversely, if you expect the euro to depreciate against the dollar, you can use a forwards contract to sell euros at a higher rate than the spot rate in the future. The difference between the forward rate and the spot rate at the maturity date is your profit or loss from the contract.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Mark Battistoni

Founder, HedgeNX Group
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Forward contracts may be tailored for international M&A transactions to address the potentially large settlement costs in a "dead deal" scenario. To address this specific risk, many banks offer Deal-Contingent forward contracts. These are tailored contracts specific to the M&A transaction and its deal-specific risks. In exchange for accepting a moderately worse rate than the at-market forward rate - the Deal Contingent premium - the acquirer gains full certainty of its cost in local currency of a foreign acquisition, like a forward contract. But it also gains full certainty that if the acquisition fails, it will avoid a potentially large "dead deal" cost.

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How can you manage foreign exchange risk with forwards contracts?

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1 What are forwards contracts?

2 How do forwards contracts work?

3 What are the benefits of forwards contracts?

4 What are the drawbacks of forwards contracts?

5 How do you price forwards contracts?

6 How do you profit from forwards contracts?

7 Here’s what else to consider

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