Forward Contract in Practice – From Order to Settlement (An Example)

Forward contracts are a fundamental tool in the toolkit of a CFO or the owner of a company engaged in international trade. They allow for the elimination of uncertainty related to future exchange rates, which translates into margin stability and budget predictability. In this article, we will guide you step-by-step through the entire lifecycle of a forward transaction, using the practical example of a Polish importer. ## Initial Situation: An Importer Facing a EUR Invoice Payment Imagine a Polish company from the SME sector that imports specialized components from Germany. The company has just received an invoice for **EUR 100,000** with a payment term of 3 months. As of today, the market spot rate for EUR/PLN is 4.3000. The theoretical cost of the transaction in zlotys is PLN 430,000. ### The Problem: Currency Risk The main challenge for the importer is the risk that the euro exchange rate will increase over the next 90 days. If the EUR/PLN rate were to rise to 4.4500, the cost of purchasing the same components would increase to PLN 445,000. This is an additional cost of PLN 15,000 that would directly erode the margin on the sold products or, in an extreme case, could render the entire batch of goods unprofitable. For a company operating on thin margins, such unpredictability is a significant threat to financial stability. The objective, therefore, becomes to lock in the exchange rate at a known, acceptable level. ## Step 1: Requesting a Quote and Executing the Forward Transaction To eliminate the risk of adverse exchange rate movements, the company's CFO decides to enter into a **currency forward contract**. They contact an FX dealer at their bank (by phone or via a trading platform) to request a quote for a forward rate to purchase EUR 100,000 with a settlement date (maturity) in 3 months. The bank, based on the current spot rate and the interest rate differential between the eurozone (EUR) and Poland (PLN), calculates the forward rate. Let's assume the offer presented is a **forward rate of 4.3180**. ### The Difference Between the Spot Rate and the Contracted Forward Rate The forward rate (4.3180) is slightly higher than the current spot rate (4.3000). This difference, known as forward points, primarily stems from the fact that interest rates in Poland are higher than in the eurozone. The bank, by "holding" Polish zloty for the client for the future purchase of euros, incorporates this cost into the transaction price. For the company, however, this is an acceptable price to pay for the complete removal of uncertainty. The company accepts the offer. The dealer confirms the transaction, and from that moment, both parties are legally obligated to settle it in the future. The cost of purchasing EUR 100,000 has been locked in at **PLN 431,800**, regardless of what happens in the currency market over the next three months. ## Step 2: The Waiting Period Until Contract Maturity Over the next 90 days, the EUR/PLN market rate will fluctuate continuously. However, for the importer's hedged position, these changes no longer affect the final cost of the transaction. Its position is "frozen." Let's consider two potential market scenarios during this period: **Scenario A: Adverse Market Movement (EUR/PLN Rate Increases)** After three months, on the contract's maturity date, the spot EUR/PLN rate is **4.4200**. If the company had not hedged the transaction, it would have to pay PLN 442,000 for EUR 100,000. Thanks to the forward contract, it incurs a cost of PLN 431,800, which generates **savings of PLN 10,200**. The hedging objective has been fully achieved. **Scenario B: Favorable Market Movement (EUR/PLN Rate Decreases)** Alternatively, let's assume the spot EUR/PLN rate has fallen to **4.2500**. In this situation, purchasing euros on the spot market would have cost only PLN 425,000. However, the company is obligated to settle the transaction at the contracted rate of 4.3180, paying PLN 431,800. This creates a so-called opportunity cost of PLN 6,800. It is important to understand that the purpose of hedging is not speculation or "beating the market." The goal is to **achieve certainty and protect the budget**. The opportunity cost in Scenario B is the price paid to avoid the much larger, potentially catastrophic risk of Scenario A. The company has consciously forgone a potential gain in exchange for the guarantee of cost stability. ## Step 3: Settlement Day (Maturity) The maturity date of the forward contract has arrived, which is also the payment due date for the invoice to the German supplier. The settlement process is straightforward and proceeds as follows: 1. **PLN Transfer:** The Polish company transfers the agreed-upon amount in zlotys to the bank with which it executed the transaction: **PLN 431,800**. 2. **EUR Transfer:** Upon receiving the PLN funds, the bank immediately transfers **EUR 100,000** to the bank account indicated by the company – in this case, directly to the supplier's account in Germany. The transaction is complete. The importer has paid for the goods with the exact PLN amount that was planned in its budget three months earlier. The currency risk has been 100% eliminated. Comparing the actual cost with the hypothetical market cost on the settlement day allows for an assessment of the hedging strategy's effectiveness. ## Non-Deliverable Forward (NDF) vs. Physical Settlement The example described used **physical (deliverable) settlement**. This means that an actual exchange of one currency for another took place. This form of settlement is standard for businesses that use forward contracts to hedge real cash flows related to imports or exports. There is also another type of contract – the **Non-Deliverable Forward (NDF)**. In the case of an NDF, there is no physical exchange of currencies. On the maturity date, the parties only settle the difference between the contracted forward rate and the prevailing reference rate (fixing) on that day. This settlement occurs in a single, freely convertible currency (e.g., USD or EUR). NDFs are mainly used for currencies with restricted convertibility or for speculative purposes by financial institutions. For a typical Polish importer or exporter, physical settlement is the primary and most useful solution. ## How does the FXrisk platform simplify forward portfolio management? A single forward contract is simple to track. The problem arises when a company enters into a dozen or several dozen such transactions per month, with different maturity dates, amounts, and at different banks. Managing such a portfolio in a spreadsheet becomes inefficient and prone to errors. The FXrisk platform was designed to solve this problem. It acts as a central system for managing the entire portfolio of hedging transactions. After executing a forward contract with a bank, the user enters its key parameters into the system. The platform offers support on several levels: * **Central Transaction Registry:** All your forward contracts are visible in one place, regardless of which bank they were executed with. You gain a complete picture of your currency exposure and hedge portfolio. * **Automated Notifications:** The system monitors upcoming maturity dates and sends reminders, allowing you to prepare funds for settlement in a timely manner and avoid costly mistakes. * **Mark-to-Market Valuation Reporting:** FXrisk automatically values the entire forward portfolio against current market rates. This allows the CFO to know the current value of their open hedging positions at any time, which is crucial for financial reporting and evaluating strategy effectiveness. Using a tool like FXrisk allows you to move from passively reacting to risk to actively and consciously managing the company's currency position, minimizing administrative work and maximizing transparency. Take control of your company's currency risk. Gain transparency and automate the management of your forward contract portfolio. [**Create a free account on FXrisk**](https://fxrisk.pl/register) --- The application is for analytical purposes only and does not constitute an investment recommendation within the meaning of applicable regulations. You make decisions to enter into currency transactions independently and at your own risk.