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Here is an example of an forward exchange contract example and how it can be used by individuals and businesses.

We’ll look at two scenarios here. Firstly an example of how a forward exchange contract can be used to help protect a couple by a holiday home abroad. Then an example of how a forward exchange contract can be used to protect a businesses profit margin when ordering goods from abroad.

Personal forward exchange contract example

In this scenario a couple are buying a holiday home in Italy for EUR 500,000.  The couple have agreed a price with the seller in Italy, but the money does not need to be paid for another 6 months.  However, the couple are worried that the GBPEUR exchange rate may move against them and therefore cost them more.

  • At the current exchange rate of 1.1755 (1/2/17) buying EUR 500,000 would cost £425,350.
  • However, if this rate moved to 1.1149 in 6 months time then EUR 500,000 would cost them £448,000.
  • This is only a move of 4.5%, if you look at the 3 month GBPEUR chart you can see this is quite possible.
  • In this case had the couple locked in the current exchange rate they would have saved £22,650

Business forward exchange contract example

In the same respect a business must protect itself from adverse currency moves.  If a business buys goods from Italy with a few to selling in the UK they can lock in the current exchange rate to protect profits.

In this instance we shall use the same figures to demonstrate how a currency forward can protect a businesses profit margin.

  • At the current exchange rate of 1.1755 (1/2/17) buying EUR 500,000 would cost £425,350.
  • However, if this rate moved to 1.1149 in 6 months time then EUR 500,000 would cost the business £448,000.
  • This is only a move of 4.5%, if you look at the 3 month GBPEUR chart you can see this is quite possible.
  • In this case if the business was expecting to make a profit margin of 10% on the sale of imported goods the adverse currency move would have in effect halved their profits.

Of course, one of the disadvantages of currency forwards is that if the exchange rate moves in your favour then you do not benefit. However, when it comes to hedging currency exposure and risk management it is very easy to protect yourself from losing money, but very difficult to predict where the markets are heading for profit.

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