In this post I aim to answer the question: why is a forward contract the ideal way to send money abroad? Someone contacted Pure FX with this question this month, and so it might prove of interest to other people planning to change currencies.
What is a forward contract?
In case you don’t know, a forward contract is a means of fixing or locking in the present exchange rate, ahead of a transaction you have planned. It’s used by people that want to take advantage of the present exchange rate, without having to move their funds abroad ahead of time.
For instance, you might need to transfer money to France to complete a purchase on a second home, but don’t need to do so for some months. If you like the exchange rate in the meantime, you can therefore lock it in with a forward contract, so that this is the rate you use when you make your transaction.
Why is it the ideal way to send money abroad?
Forward contracts provide two distinct advantages:
- They protect you against unfavorable changes in the exchange rate closer to your transfer date.
- They therefore provide peace of mind about your transfer.
For people planning to purchase a home for instance, they are ideal, as I mention. This is because on a large transfer, just a small movement in the exchange rate can have a big impact on your foreign currency total. Hence a forward contract shields you from these uncertainties.
Are there any downsides?
Unfortunately, yes. Although a forward contract can protect you against declines in the exchange rate, it can also prevent you taking advantage of increases closer to your transfer date. The foreign exchange market goes up as well as down after all, and no one can accurately predict what will happen one day to the next. Hence using a forward contract does involve a little bit of playing the odds.
If the pound hits a nine-month high against the euro for instance, it’s our experience that it’s better to secure that exchange rate there and then, rather than wait and bet on it rising higher. This is because, more often than not, the pound comes down again quite quickly, by which time the opportunity for you to secure a great rate has gone. In this sense, forward contracts are about being cautious with your money.