Why Forward Contracts Are Better than Options or CFDs to Protect Yourself
One of the greatest difficulties when transferring money abroad is locking in a favourable exchange rate. The traditional method of exchanging one currency for another via banks tends to subject customers to the volatility of the Forex market. As a case in point, consider the cable (GBP/USD) which may be trading at 1.40. A person in the United Kingdom wanting to transfer £100,000 to the US expects to receive approximately $140,000. However, if the rate unexpectedly drops to 1.35, the £100,000 will only be worth $135,000.
For this reason, many Forex traders are turning to forward contracts to hedge (guard against) Forex market volatility. If it is possible to lock in a fixed exchange rate ahead of time, the sender/receiver knows exactly what to expect, and can plan accordingly. It is against this backdrop that we examine forward contracts versus other alternatives such as Contracts for Difference (CFDs), options, and keeping cash reserves in several currencies (high risk of theft or loss). CFDs are a popular choice for hedging purposes, since they allow you to generate profits when markets move in a bearish direction.
For example, if you held a dollar-denominated asset and the USD started depreciating, you could hedge against losses by taking out CFDs. CFDs are commonly used with shares that start losing value. By hedging with CFDs, you can protect your investment with a counter investment that moves in the opposite direction. Typically, shares need to appreciate for profits to be generated, but if share prices begin to plunge, CFD put options can be taken out.
Unfortunately, with CFDs, your trades are subject to unlimited losses since leverage is involved. If markets turn against you, you could be on the hook for more money than you expected, rendering your CFD hedge a worse investment. You also may be subject to increasing margin payments (to cover adverse movements in prices) as markets continue moving against you, without realizing any gains from the CFD.
What Is Hedging in Forex
Hedging is used to protect against unfavourable market movements. The Achilles’ heel of Forex trading is volatility. Cross currency exchange rates can fluctuate wildly from day-to-day, making it difficult to gauge how much you can expect to receive when you convert one currency into another. Forex forwards (FX forwards) are preferred to Forex futures for a number of reasons. Forex forwards are flexible investment options which can be priced for a specified settlement date. These date-matched financial instruments are preferred by many Forex traders as the perfect hedging option. Forex futures by contrast are rather limited in terms of the value dates that are carved in stone.
With Forex futures, the value of transactions processed can be significantly smaller, and they are often associated with lower trading costs overall. As an investor shifting money back and forth, you can use Forex forwards to hedge against the performance of currencies. There are no extra fees for settlement with Forex forwards, but with Forex futures, the transactions are not free. Another benefit of using Forex forwards vis-à-vis cost savings is liquidity. There are a multitude of players in the Forex forwards market, and thanks to over-the-counter liquidity, there is significant the less resistance for real money Forex transactions with Forex forwards.
There are no specific commissions when it comes to Forex forwards, but the fees are apparent in the spread (the difference between the buying price and the selling price of the currency pair). As a hedging vehicle, Forex forwards offer many more benefits over Forex futures. The cost savings are a case in point. Forex futures are executed on central exchanges, and brokers receive commissions from these trades. The centrality of Forex futures differs from the OTC nature of Forex forwards. With Forex futures, there is a great degree of regulation and compliance, and all participants must be licensed to partake in it. While the definitions of Forex futures versus Forex forwards creates uncertainty or confusion, we can some these differences up in 4 clear points:
- Forwards are essentially unregulated while futures contracts are heavily regulated.
- Futures contracts are subject to clearing house guarantees and forwards have a degree of credit risk
- Futures contracts take place on regulated exchanges while forwards are customized for your specific needs
- Forward contracts are private transactions, and futures contracts are reported publicly to the futures exchange
There are long and short positions with futures contracts. A long position takes place when the buyer purchases the contract for a later date expecting the price to increase. A short position occurs when the seller concurs that the underlying contract will be sold later or at an expiry date with a price that is agreed to at inception. The seller will benefit when the price decreases.
Why do SMEs and investors prefer forward contracts with Forex transfers?
Small and medium enterprises can benefit immeasurably from forward contracts. For starters, you can lock in a guaranteed exchange rate for a future date. Not only do these minimize exchange rate risks, they also allow you to plan to ensure that you get X amount for your Forex exchange. This is especially important when you’re looking to purchase real estate or other big-ticket items abroad. Companies are particularly reliant on forward contracts to ensure that they can guarantee their cost/revenue streams in their home currency. With a forward contract you can expect to settle 10% of the contract value upfront, and the rest will be deliverable when the contract reaches maturity. It is possible to project ahead as far as 1 year for major currency pairs and as much is 5 years for leading currencies like the EUR/GBP, GBP/USD, and others. The pricing associated with forward contracts is easy to understand. There are several factors that determine prices:
- Interest Rate Differentials
- Time until Maturity of the Contract
- The Spot Exchange Rate of the FX Pair
Somebody who is purchasing property abroad wants to ensure that they have the necessary funds locked in to make the purchase. If you’re living in the United Kingdom and you wish to buy property in the US, the value of each £1 is sacrosanct. If you’re banking on a rate of $1.40 for every £1, then it’s important to lock in that rate to ensure that you can afford the overseas investment. If the exchange rates move against you such that every £1 is worth $1.25, this will be to your detriment. Forward contracts allow you to essentially lock in the exchange rate so that you don’t have to worry about being short. This is a desirable hedging tool which eliminates or mitigates much of the risk to allow you to transfer Forex internationally with greater certainty.
Naturally, it’s important to choose the right international money transfer companies for these forward contracts. World First and Transferwise compared much more favourably than banks and established financial institutions when it comes to providing SMEs with forward contracts. These international money transfer organizations rank among the best in the business and have conducted billions of dollars in international funds transfers, with many individuals and corporations choosing forward contracts to lock in the best rates and hedge against volatility in the currency markets.