Currency of the Contract: Everything You Need to Know
Currency of the contract is an important consideration when entering into an agreement with a business in a foreign country with a different financial system.3 min read
2. Currency Futures
3. Spot Rate Versus Futures Rate
4. Counterparty Risk
Currency of the contract is an important consideration when entering into an agreement with a business in a foreign country with a different financial system. Because issuing and receiving payments in another currency carries risk, it is often a key point in negotiation of this type of contract.
Risks Associated With Foreign Currency Contracts
The value of the foreign currency in question can sometimes change substantially after this type of contract has been signed, so the company may end up paying much more or less than expected. The longer the contract term, the greater this risk.
Currency value depends on supply and demand and is affected by factors such as:
- Economic growth
- Inflation rate
- Interest rates
- The country's political stability
Newer nations often the value of their currency value to that of the Euro.
During the negotiation of an international contract, the negotiating party must decide whether:
- Both companies will share the risk.
- The risk is shouldered by the foreign partner.
- The risk is assumed by the negotiator's party.
- The contract allows for renegotiation of the currency denomination if necessary.
Businesses often protect against exchange rate changes with a foreign exchange contract. This agreement is a promise to sell or purchase a certain amount of foreign currency on a specific date. A transferable contract known as "currency futures" provides a price at which a specific currency can be purchased or sold on a future date.
This type of contract is legally binding, and the pair of currency must be traded by the parties holding the contract on the delivery date at the specific price. This allows investors to increase profit by speculating on exchange rate changes or avoid a loss. These contracts are marked to market every day, which means that investors can sell before the delivery date.
The price is determined when the contract is signed, and it is upheld regardless of the currency value on the delivery date. Quotes for major exchange pairs such as Euros and dollars can be obtained for dates up to 10 years away, while forward exchange rates are available for one year in the future.
Exchange rates consist of:
- The currency's spot price
- The transaction fee charged by the bank
- An adjustment in the difference of the interest rate of each currency, allowing the country with a lower interest rate to receive a premium trading price, while the country with the higher interest rate trades at a discount. To calculate this adjustment, use the formula (exchange rate x interest rate differential x contract duration in days) / 360 = premium / discount
Forward contracts are usually negotiated between a company and the bank it uses. The company must make an initial payment to the bank and a final payment before the date on which the contract is settled. This type of contract is highly customized, so usually, neither party can transfer it to a third party. Comparing offerings between banks is also challenging, and fees tend to be high.
Sometimes a forward contract is created for a transaction that has been canceled. In this case, it can be offset by a second forward contract. Although this will relieve the company's obligations, it will carry a second fee. Both parties must agree to terminate the contract early in order to do so.
Spot Rate Versus Futures Rate
The current exchange rate is the current rate quoted for purchase or sale of a currency pair. At this rate, the trade must take place immediately after the agreement to trade. Currency futures rates are affected by the change in spot rates. They tend to increase when spot rates go up and decrease when spot rates go down.
This risk describes the chance that the counterparty on a forward currency contract will not meet his or her obligations. This counterparty, usually a large international bank, carries only the risk of the contract profit or loss.
If a company has several forward currency contracts with the same bank, the risk of the counterparty is still the net profit or loss on these contracts, although sometimes collateral may be put up in this instance.
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