FX Forward Contracts 101: How To Protect Against British Pound Volatility

What happens when you ask six foreign exchange experts what is in store for the British pound in 2021? You get eight different opinions. At a time when top foreign exchange experts can’t agree on the British pound outlook, individual investors and business owners can easily protect themselves through FX forward contracts.

The advancement of fintech platforms and digital money transfer services gives investors convenient access to hedge their British pound and other foreign exchange exposure and limit potential downside.

Unclear If The Pound Gain Or Lose Value

The United Kingdom is now a completely separate entity from the European Union with new rules and laws in effect as of the start of 2021. While this may have eliminated a major overhang for the British pound, experts are making compelling cases both for and against the national currency.

On the bearish side of the British pound outlook, several mega-large fund managers kicked off 2021 with a short sterling position. A short position is a bet against the pound and generates a profit if the currency loses value.

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“With sterling having failed to rally materially on the back of the Brexit deal — versus the euro — we are now inclined to see it underperform,” BlueBay Chief Investment Office Mark Dowding told Bloomberg.

Another asset management, Allianz Global Investors, is also betting on the pound losing value. The firm believes that the Brexit deal is “in fact bad for the U.K.” and there is a “very high probability” that Scotland will leave the UK and Northern Ireland will rejoin Ireland.

But at the same time, other fund managers are bullish on the pound and expect it to move higher. According to Bloomberg, Gregory Perdon, a co-chief investment officer at Arbuthnot Latham, the pound should move higher as recent signs of momentum “serves as an invitation for international investors.”

The Solution: FX Forward Contract

An FX forward contract, also referred to as a currency forward, is an agreement between two parties to buy or sell a currency pair at a pre-agreed exchange rate on a guaranteed date. The terms of the agreement cannot be changed and will be valid regardless of the actual currency rate in the future.

Here is a basic example:

Suppose you reside in the United Kingdom and will be purchasing a property in Portugal in six months for €500,000. At current exchange rates, the price tag on the foreign property is around £444,000.

Despite the UK resolving the Brexit trade issue, much can change over the six month period that would impact the pound. The COVID-19 pandemic continues to ravage the world. Nearly a full year into the health crisis and the UK along with many other countries are reporting record daily death numbers.

As such, it is possible the pound loses 4% in value against the euro, if not more in half a year. But even assuming a 4% decline, the same €500,000 property will cost £460,000. This scenario isn’t far-fetched as the British pound has on several occasions lost more than 1% against the euro in a single day.

Instead of sitting back and hoping the exchange rate doesn’t move unfavorably, you can enter into a pound forward contract. As part of the currency forward, you enter into an agreement to exchange £444,000 for €500,000 in six months, even if the spot rate for €500,000 is £460,000.

The counter-party on the other end of the contract likely has similar needs — but in reverse. Perhaps they are a German-based investor looking to invest €500,000 in a British business in six months. Much like the property buyer, the German investor wants to protect their money from losing value by default of unfavorable foreign exchange movements.

The main drawback of an FX forward contract is if the pound appreciates in value, the holder misses out on gains. For example, suppose the pound gains 4% then the same property would have cost around £425,000 without a forward contract.

However, individuals shouldn’t look at this from this perspective as the main objective of a pound forward is to guarantee a rate and protect against downside. For the vast majority of people who take an FX contract, foregoing potential savings is an acceptable outcome if it guarantees to avoid higher costs.

Source: Bloomberg

Who Uses Pound Forward Contracts?

Currency forward contracts are mostly used by individuals transferring a large amount of money. For most people, hedging small amounts of money where the downside is £10 might not be worth the time and effort. But certainly in the example above, hedging the cost of a property could save someone tens of thousands of pounds.

Companies that do business internationally are also heavy users of forward contracts and for good reason. Medium-size enterprises that transfer millions of pounds to and from the UK must protect their exposure to avoid potentially devastating losses through no fault of their own but due to currency fluctuations.

More people and individuals turned to currency forward contracts in 2020 as fintech and money transfer services gained in size and scope and were better able to advertise their products and services to more people.

Conclusion: How To Buy A Forward Contract

There are dozens of companies dedicated to offering FX forward contracts to individual and corporate clients. Some of the more widely known and popular companies include:

  • AxiaFX Money Transfer
  • Currencies Direct
  • Currency Solutions
  • OFX
  • PureFX Money Transfer
  • XE Money Transfer

In most cases, a 10% deposit on the total size of the forward contract is required upfront and the remaining 90% will be deliverable when the contract reaches its maturation or expiration date. Most forward contracts are taken out for one year but it isn’t uncommon to find contracts that last five years.

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