Changing the Way You Change Your Money –
Ever wonder what a currency forward contract is? If not, don’t worry because you aren’t alone. Most people haven’t either but anyone who needs to exchange their foreign currencies should really asess whether it pays to buy a currency forward contract vs. buying a foreign currency outright.
A currency forward contract is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. For example, instead of walking into your money changer’s store with US dollars and walking out with Israeli Shekels several minutes later, a purchaser of a currency forward contract puts a deposit down and agrees to wait to pay for and take delivery of the Shekels at a later date. Generally, a bank or other financial institution guarantees actual receipt of the Shekels at the later date and the person on the other side of the transaction (i.e. the person who agrees to pay you the shekels at a later date in exchange for the US dollars that you have agreed to pay them at the later date) also puts up a security deposit to assure performance.
One can often get better pricing on a foreign exchange rate if they are able to wait for delivery of their foreign currencies. Specifically, if you are buying Israeli Shekels in exchange for your US Dollars, British Pounds,Euros or Canadian Dollars this is always the case. I.e. at the current time, you will always get more Israeli Shekels if you agree today to take delivery of your Shekels at a later date in exchange for the aforementioned currencies than you would today.
When the risk free interest rates of a foreign country is greater than the interest rate of the country issuing the currency you are exchanging , this is always the case. Israel has a current risk free interest rate (as of 2011) of 3.25% per annum, an interest rate greater than the US ( 0.25%), the UK (0.50%), the European countries who use the Euro as their currency of exchange (1.5%) and Canada (1%).
If you are selling these lower yielding currencies in exchange for the higher yielding Israeli Shekel, the reason that you will always get a better exchange rate by agreeing to wait to take delivery of the Shekels is because the currency market is transparent and efficient. No reasonable seller of the lower interest rate yielding currencies would agree to accept the same rate of exchange in the future as is being paid today and forego the interest they can earn on the Shekels if they bought the shekels today. E.g. Suppose you need to exchange $100,000 USDs for Shekels and the exchange rate today happens to be 3.60 (1 USD = 3.60 Israeli Shekels /ILSs(Note: In the currency exchange market Israeli Shekels are known as ILS not NIS). If someone came to you and told you that they would pay you 360,000 ILSs but only in a year from now would you do it? If you would agree to do it you have agreed to a bad deal. This is because , instead of waiting out the year to get your Shekels while earning 0.25% interest or $250 USD on your $100,000 USDs, you might as well exchange your $100,000 USDs today with someone else for 360,000 ILS and deposit your 360,000 ILS in the bank for 3.25% interest for 11,700 more ILS (360,000 ILS x .0325=11,700 ILS). If you agreed to the deal you have just caused yourself a loss of 11,700 ILS in exchange for a gain of $250 USD ( equalling 900 ILS)and in total you have lost 10,800 ILS (11,700 ILS less 900 ILS). The cost of th Shekel in the future therefore is always lower than it is today with respect to lower yielding currencies i.e. you will always get a higher exchange rate for your US and Canadian Dollars, Pound and Euros if you agree today to take delivery of your Shekels later.
This being the case, one should always assess whether or not they really need to take delivery of their Shekels right away. If not, a forward contract should be entered into and delivery of the Shekels should be postponed for a better exchange rate. This is often the case with real estate transactions. Often a large sum of low yielding foreign currency needs to be exchanged for Shekels because purchases of real estate in Israel are generally made in Shekels. A real estate transaction takes time and the Shekels are not needed immediately. In general, if you are buying an apartment in Israel and you really want to buy that apartment, it is extremely wise not to gamble with exchange rates. If you are set on the apartment and your cost in US dollars (or in any other currency for that matter) is acceptable to you (based on the exchange of the time) you should either exchange the US dollars (into Shekels) that you need to spend on the purchase right away or buy a currency forward contract through a currency specialist to hedge yourself against any further weakening of the US dollar (or other currency). Leave currency speculation to others and concentrate on your goal which is to buy an apartment in Israel. Just remember that the exchange rate that is here today may be gone tomorrow.
One can also take advantage of foreign currency forward contracts to earn higher interest rates available to depositors overseas while keeping the majority of one’s money FDIC insured. Many foreign banks follow fiscal policies of keeping interest rates high to attract foreign investment amongst other reasons. As long as inflation is stable in those countries and as long as a depositor is willing to bear the currency risk involved, it may seem like an attractive investment to merely buy a CD (or time deposit as it is sometimes called) in an overseas bank where interest rates are higher or at least more respectable. The problem is that these banks are generally uninsured. I have a relative who lost about $100,000 depositing her money in an allegedly stable yet uninsured bank in South America that offered her a high cash deposit interest rate. To solve this problem and minimize the risk a currency forward contract can be purchased on the higher yielding currency while keeping the majority of your money safe in a US FDIC insured bank (which insures deposits up to $250,000 and insures foreign currency deposits as well). Since the market is efficient as explained above, the exchange rate on the higher yielding currency bought with a forward contract will be better than the exchange rate of today. One will in effect earn the equivalent of the risk free rate of the higher yielding currency (in the form of more foreign currency coming to them in the future) by waiting to take delivery of the foreign currency. For example, the consumer can still earn the 4.75% available to Australian depositors where interest rates are generally high and keep most of their money insured in an FDIC bank and not worry about a bank insolvency.
Gershon Kayman, Esq. is a seasoned real estate lawyer both in NY and in Israel. He can be reached at firstname.lastname@example.org