Unless they are about to go on holiday, the average person on the street doesn’t think much about exchange rates. However, they matter a great deal to businesses, real estate investors, and finance professionals.
Just like poker, Forex trading is a hard way to make an easy living. To the untrained eye, there’s doesn’t appear to be much to it: buy currencies when they plunge, and then sell once they rally – right?
If it were that easy, everybody would be doing it. Currencies are volatile by their very nature – scores of factors can influence the value of a nation’s money supply. Many are impossible for the casual observer to predict – unless you had an inside source, you’d have no idea whether a country’s central bank was going to raise interest rates or leave them be.
Other factors also play a role in currency movements – these include employment reports, energy production, or the election of a non-status quo government. All can inflate or deflate the value of a nation’s currency.
How can professional Forex traders (or anyone else who has to move money across borders) overcome unpredictable markets? In this article, we’ll teach you how to use hedging instruments to protect yourself from financial ruin.
The world is a crazy, volatile, unpredictable place
If this world is a simulation (like Elon Musk suggests it is), it’s certainly a convincing one. The sheer volume of crazy events that happen from year to year makes it impractical to think any programmer would create such a system.
The utter failure of our society’s leading experts to predict ‘black swan’ occurrences like the Great Recession makes it next to impossible to predict where currency rates are going. According to IMF macroeconomist Prakash Loungani, we have failed to predict 148 out of the last 150 recessions – a stunning failure rate of 98.7%.
It is shocking that in the 21st century, we are still not able to foresee macroeconomic events that could have dire consequences for businesses and individuals. Of all people, we’d expect Janet Yellen, former chair of the Federal Reserve, to recognize the warning signs. However, even she missed the forest for the trees, acknowledging in 2016 that she didn’t see the risk that the 2000s housing bubble posed to the economy.
Knowing this, how can any trader (let alone non-finance professionals) predict microeconomic events, like day-to-day movements in currency markets? They can’t – but it doesn’t stop scores of them from trying every single day.
Forex trades are highly leveraged – this makes it easy for some traders, who are motivated by the desire to make quick money, get in over their head. Expecting a currency pairing to move in one direction, all it takes is something like the sudden imposition of tariffs to clean out a trading account.
Hedging your bets: introducing the forward contract
Currency rates may be inherently unpredictable, but 4% of Forex traders still manage to post consistent profits. How do they overcome the volatile nature of money markets? They employ hedging strategies to protect their assets from ‘black swan’ events.
The forward contract is one tool in their arsenal. What is a forward contract? It is a deal between a buyer and a seller of a commodity (in this case, currencies) to execute a sale at a future date at an agreed-upon price.
They are similar to futures contracts in many ways, but with a few key differences. First, futures are traded through an exchange, while forwards are private deals that are loosely regulated. Second, futures are settled on a day-to-day basis, while forwards are paid out on the date of maturation. Finally, futures are bought mostly by speculators, while forwards are favoured by parties who intend on completing the contracted transaction.
For these reasons, forward contracts are preferred over futures for hedging purposes. But, how exactly does forward contract pricing work? Let’s say you’re British – you want to buy a holiday home in Canada, but you and your seller are worried about the impact that oil price fluctuations or the outcome of Brexit would have on the GBP/CAD pairing.
To protect each other’s financial interests, you both come to a negotiated settlement that locks in a guaranteed exchange rate, like 1.70 CAD:1 GBP. While either party may have to pay more or earn less than they otherwise would, the cost certainty created prevents a situation where one side’s finances are adversely impacted by unexpected movement in the markets.
Still not clear on the process? On this linked site, forward contract pricing explained in a straightforward manner – check it out.
Where can you get your hands on a forward contract?
About to purchase real estate abroad and want protection from sudden currency fluctuations? Taking up currency trading and want to reduce your risk of ruin? In these and other situations, forward contracts are often the best way forward.
Forward contracts used to be hard to secure. Not anymore – these days, an increasing number of money transfer companies are offering these products to their customers. Some providers provide terms as long as 24 months – this covers business transactions (e.g. paying vendors & offshore employees), real estate, the repatriation of expat bank accounts, and much more.
Currency markets can get rough: protect yourself
One unexpected move in the markets is all it takes to inflict economic pain on a business or an individual. By employing hedging measures like forward contracts, you can buy yourself some badly-needed peace of mind.