Foreign exchange contract definition
/What is a Foreign Exchange Contract?
A foreign exchange contract is a legal arrangement in which the parties agree to transfer between them a certain amount of foreign exchange at a predetermined rate of exchange, and as of a predetermined date. This arrangement is useful when an organization wants to engage in international purchases or sales, without the risk of incurring foreign exchange losses caused by subsequent changes in the applicable exchange rate.
Who Uses Foreign Exchange Contracts?
Foreign exchange contracts are most commonly used when an organization buys from a foreign supplier, and wants to hedge against the risk of an unfavorable foreign exchange rate fluctuation before the payment is due. Speculators may also use these contracts, to attempt to profit from expected changes in exchange rates.
Example of a Foreign Exchange Contract
In a sample foreign exchange contract, the buyer is Import Corporation, while the seller is Big Bank. The date of the contract is December 4. Under this contract, Import Corporation anticipates paying €1,000,000 to a European supplier in 90 days (on March 4). To avoid the risk of unfavorable currency fluctuations, Import enters into a forward contract with Big Bank to lock in today's exchange rate, which is 1 EUR = 1.10 USD, in the amount of €1,000,000.
On March 4, Import Corporation will deliver $1,100,000 USD to Big Bank, while Big Bank will deliver €1,000,000 EUR to Import Corporation.