A Forward Exchange Contract allows investors to secure a guaranteed exchange rate, despite not actually buying it until a specific future date. This may seem like a gamble or speculative if used in isolation, but it is important in mitigating risk.
The exchange rate may go in your favour or not when you prepare for future transactions. When this transaction is say, your life savings in buying a house abroad, then it is probably best to secure an exchange rate now, rather than let the market decide your fate.
Often, you will lose out on a small spread margin, or perhaps miss out on the market moving in your favour. This is worth the hit when you understand how quickly prices can change.
What causes fluctuations in currency is often speculation or an uncertain environment. For example, the pound slumped over 7% against the euro imminently after the Brexit referendum result in 2016. When you have major political events such as Brexit on the horizon, the uncertainty can pose as too much of a currency risk for many.
With the speed of transactions increasing, and with a decentralisation of financial infrastructure because of the rise of fintech startups, there is more opportunity for retail investors and everyday folk to take advantage of financial instruments that were once only accessible to investment banks. In fact, XE reviews say that they offer Forwards.
Derivatives get a bad press. They tend to only be in the mainstream narrative when it regards their illegitimate abuse by investors. They are also perceived as high risk and unsuitable for those with shallow resources, or even retail investors in general. This is simply not true, it is how you use them.
Presuming a sufficient amount of investor education, anyone can buy Forwards contracts or options. Used properly, they are a means to reduce risk, not take risks. For example, both derivatives tend to be mostly tools of hedging, a means of mitigating exposure.
The reasons why options can be used to mitigate risk is because they set an exchange rate which can be used to change currency. Overtime, if the exchange rate become unfavourable, then this option can be exercised and get a better rate than what exists today. On the other hand, if the exchange rate become recently more favourable, then the option does not need to be exercised, and today’s rate can be used instead. Other than a fee, potential losses are contained and limited through the use of options, similar to Forward contracts.
These derivatives are often taken advantage of by those who will have a sizeable amount of money in a foreign currency. For example, if you have received an inheritance in a foreign currency, and you do not want to be exposed to that currency crashing. The same goes for future expected income, like selling a house abroad or renting it out, then locking in a specific rate that you can use in the future may be wise.
Another way, though it is more of a technique than a tool, is to hedge against your currency with gold. It is well established that gold and the US Dollar has an inverse relationship – they are negatively correlated. This means that when the US goes through economic difficulty and the dollar devalues, gold usually strengthens because it is seen as a safe, intrinsically valuable alternative. The same applies to GBP, although the relationship is slightly weaker (no relationship is still great for diversifying, though). Thus, if you possess a high amount of pound sterling in cash or savings, diversifying this with some investment in gold could potentially mitigate a large amount of currency risk.
Why is this increasingly important for Brits?
The Sterling has a rough road ahead. With the imminent stepping down of Theresa May, hard-line Brexiteer Boris Johnson looks to be favourite to replace her at number 10. Brexit is riddling the UK’s currency and economy with anxiety, and uncertainty is perhaps the most dangerous feature of an economy.
The pound had hit a 31-year low upon the Brexit referendum result in 2016. A 10% drop against the USD and a 7% drop against the EUR, the worst is perhaps yet to come. The slump represented shock and uncertainty, but didn’t even conceive of the no-deal Brexit idea that seems a plausibility.
Those with real estate abroad or savings in Europe will likely be trying to sell or exchange prior to Brexit, but if this is not the case, then hedging risk using derivatives is perhaps the very least they can do to try and reduce losses. It seems like something out-of-reach of retail investors or retirees, but this is a common fallacy that does not apply anymore.