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Forward Contracts For Currencies
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The foreign exchange market is a form of exchange for the global decentralised trading of international currencies. Financial centres around the world function as anchors of trading between a wide range of different types of buyers and sellers for currencies. For example, a business in South Africa may import goods from the USA and pay in US Dollars ($), even though its income is in Rand.
Forward Contracts
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed-upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the transaction can be one day, month or year.
Example:
“A” will receive $10 000 in 3 month’s time. The current exchange rate is R8,25 for $1. The market expects that the Rand will weaken over the next 3 months (maybe R7,90). “A” can cover this potential loss in a forward cover deal. “A” and “B Bank” agree on R8,30 for $1 after the 3-month period on a specific date.
For “B Bank” to offer this rate, it uses an interest financial instrument/investment.
“A” must have controls and plans in place to evaluate the current markets to ensure the efficiency of the financial instruments he uses.