Key Takeaways

  • The currency of contract is the currency in which the contract price is stated and payments are made.
  • Currency fluctuations introduce risk for international agreements, especially long-term contracts.
  • Parties can manage this risk by sharing it, assigning it to one party, or including renegotiation clauses.
  • Tools like currency futures and forward contracts help mitigate foreign exchange risks.
  • The spot rate is the current exchange rate, while futures rates are predictions based on interest rate differentials.
  • Counterparty risk refers to the chance a party in a currency agreement defaults on the obligation.
  • Legal clarity on contract currency and jurisdictional compliance can significantly reduce future disputes.

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.

What Does Currency of the Contract Mean?

The currency of the contract refers to the specific monetary unit in which the total contract price is stated and all financial obligations are settled. This definition is crucial when negotiating agreements across borders, as it affects how payment obligations are calculated and fulfilled. According to Law Insider, the "currency of the contract" specifically means the currency in which the contract price is expressed​.

Including this clause clearly in a contract eliminates ambiguity and sets expectations for exchange rate use, payment amounts, and possible adjustments. It is also the currency used for dispute resolution involving financial terms.

Currency Futures

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.

Choosing the Right Contract Currency

When forming an international agreement, businesses may choose a contract currency based on:

  • Stability and predictability (e.g., USD, Euro, GBP)
  • Location of business operations or markets
  • Currency in which company expenses are primarily incurred
  • Minimizing exchange rate conversion costs

If one party is based in an emerging market with a volatile currency, using a stable foreign currency can reduce the risk of devaluation. However, this might shift the exchange rate burden to the domestic company.

Some contracts also incorporate multi-currency clauses that allow invoicing in multiple currencies or enable the recipient to choose their preferred currency from a set list. These clauses should clearly define the method of conversion and exchange rate reference date.

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.

Legal Considerations for Contract Currency Clauses

When drafting a contract that involves foreign currency, it's essential to:

  • Clearly specify the currency in which all payments are to be made.
  • Define whether exchange rate fluctuations will be borne by the buyer, seller, or both.
  • State the applicable exchange rate source (e.g., mid-market rate published by a central bank).
  • Include clauses allowing renegotiation in case of extreme volatility.
  • Determine jurisdiction and governing law, especially if the exchange rate fluctuates significantly due to government intervention.

Some contracts also contain “currency conversion provisions” that explain how non-payment in the stated currency will be handled, including penalties or default remedies.

Counterparty Risk

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.

Frequently Asked Questions

  • What is the currency of the contract meaning in legal terms?
    It refers to the currency in which all financial obligations, including the contract price and payments, must be fulfilled.
  • Why is specifying the contract currency important?
    It reduces ambiguity, helps manage exchange rate risks, and prevents disputes between international parties.
  • Who bears the risk of currency fluctuations?
    This depends on the contract terms. It may be assigned to one party, shared, or negotiated with renegotiation triggers.
  • What tools help mitigate currency risk in contracts?
    Currency futures, forward contracts, and multi-currency clauses are commonly used tools to manage such risk.
  • Can a contract be changed if the currency becomes unstable?
    Only if the agreement includes a clause allowing renegotiation or termination under severe currency fluctuation scenarios.

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