A forward contract against an export is an agreement between the importer and exporter to exchange a specified amount of the importer's currency for the exporter's currency. This is done on the date payment for an export is due, using the existing currency exchange rate at the time the contract for sale is made.
The forward contract's purpose is to provide a hedge for the importer and exporter against the risk of fluctuations in currency exchange rates, which may occur between the time the contract for sale is made and the time when payment is actually rendered. This is accomplished by the forward contract, specifying the sales price in terms of how much of the importer's currency is required to satisfy the sales price with the exporter's currency.
Without a forward exchange contract, either party risks the possibility of suffering financial loss from a significant change in the exchange rate between the importer's and exporter's respective currencies between the time they settle on a price and the time of delivery of goods and payment. For example, if the importer's currency dropped in value 20% against the exporter's currency in the interim between contract for sale and payment, the importer would effectively be forced to pay 20% more for the goods purchased than he was expecting to pay at the time he contracted to buy them.
The primary advantage of a forward exchange contract is it assists the parties involved in risk management. The certainty provided by the contract helps a company project cash flow and other aspects of business planning.
The disadvantage of the forward contract is that neither party can profit from a significant currency exchange rate shift in their favor. For this reason, sometimes the parties involved make a forward exchange contract for only part of the total sales price, thus leaving open the possibility of profiting from exchange rates moving in their favor. Forward contracts can be made for up to a year in advance. They are typically created by the exporter's financial institution.