Do Forward Exchange Contracts offer good protection against exchange risk?
Are you an expatriate in Switzerland or a cross-border worker who would like protection from exchange risk? Many individuals turn to the forward exchange service offered by their bank in the belief it will bring them risk-free savings. But it is unlikely to be the right choice. We explain why in this article.
What is forward exchange?
Forward exchange is a signed contract between an individual and a bank in which the bank locks in an exchange rate that will be used for a number of currency exchanges over a period of months.
In the context of exchanging Swiss francs for euros, a Forward Exchange Contract commits bank customers to sell a given number of Swiss francs to the bank each month in exchange for a set number of euros at the rate given in the contract.
Forward Exchange Contracts usually have a duration of 3, 6 or 12 months and protect individuals from unfavourable fluctuations in the exchange rate between currency pairs. Bear in mind this also means they cannot benefit from favourable developments in the rate. Setting the rate can be an attractive proposition in terms of budgeting transparency.
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How does a Forward Exchange Contract work?
How it works
To calculate the forward exchange rate, banks use existing market variables, i.e:
- the spot rate, i.e. the current rate of conversions;
- the lending and borrowing rates of the currency pair over the agreed payment dates in the contract.
This information helps the bank put forward a forward exchange rate that, consequently, is not based on the expected rate at the end of the contract.
When the bank signs a Forward Exchange Contract, they have recourse to a Futures contract on the currency market, through which it commits to sell a certain amount of Swiss francs by a given deadline, in exchange for which it will receive an equivalent sum of euros at a predetermined exchange rate.
To protect themselves against exchange risk, a cross-border worker concludes a Forward Exchange Contract with their bank. The bank is committed to applying the same forward rate each time their customer transfers their money back home for a duration of six months. For example, six separate exchange transactions of 3,500 Swiss francs at a rate of 0.9%.
In return, the customer undertakes to supply the agreed sums on specific dates, say 21,000 Swiss francs over six months. On each monthly payment of 3,500 Swiss francs, the bank will credit its customer’s account with €3,150 – a total amount of €18,900 at the end of the set period.
Forward exchange contracts – limiting and inconvenient
While they may appear to be an effective option against exchange risk and consequently a way of saving money, the reality is that Forward Exchange Contracts are very expensive.
To benefit from the protection they offer a customer can expect to pay:
- set administration fees of around a hundred euros at most banks;
- an (often considerable) exchange margin that is decided by the bank.
The latter can cancel out any savings in the event of adverse changes in the exchange rates.
Good to know: For a customer exchanging 5,000 Swiss francs a month over a year, a bank could take up to €900 in exchange charges!
Furthermore, if by unlucky chance the Swiss franc strengthens over the year, the customer will lose out on two counts!
Forward exchanges contractually oblige customers to pay monthly sums to their bank. But sometimes life can get in the way of you honouring these payments.
While personal reasons, an accident, or an unexpected expense are all legitimate reasons, they will matter little to your bank and it will have every right to charge a penalty. Making ends meet can be difficult.
Should there be any complications with your professional situation or your income stream, you could end up converting euros into Swiss francs and then exchanging them back into euros because of this exchange guarantee. Ending up paying two sets of exchange fees!
Finally, although some banks may talk about the possibility of giving notice on a Forward Exchange Contract in the event of redundancy, this process will not be free. Read the terms and conditions of your forward contract and you will see that the longer the time remaining on the contract, the higher the penalties will be to cancel it due to redundancy.
Forward selling – advice and alternatives
If you still intend to enter into a forward selling contract despite these warnings, this is our advice:
- Limit the amount of income you commit to an exchange guarantee to 30%. If the contract does not allow this (e.g. because it is an insufficient amount), do not enter into the agreement. For the remaining 70% or for your entire salary, consider an online exchange service at a preferential rate.
- Limit the duration of the contract to three months. A short duration will give you more control in the event of any problems. Definitely avoid contracts of six or 12 months.
- Before signing, familiarise yourself with any hidden terms and conditions. Ask difficult questions about the required conditions for terminating the contract, the cost of doing so, what happens in the case of redundancy, defaulting on payment, etc.
An alternative to forward exchange
Expensive and risky – the Forward Exchange Contracts offered by banks are not a great way to protect yourself against exchange risk.
b-sharpe offers private individuals a more cost-effective, secure and efficient alternative via its online exchange service. It has more attractive and transparent margins!
Good to know: As an intermediary for private individuals, b-sharpe does not offer exchange guarantees.
b-sharpe customers can set the rate of exchange in real time by calling our customer service department during working hours. With the rate fixed, customers have 48 hours to transfer their funds and so protect themselves against any fluctuations between sending the funds from their bank and their receipt by b-sharpe.