Forward Market

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Forward Market

• The forward market facilitates the trading of forward contracts on currencies.

• A forward contract is an agreement between a corporation and a financial institution (commercial bank) to exchange a specified amount of a currency at a specified exchange rate (called the forward rate) on a specified date in the future.

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Forward Market

• When MNCs anticipate future need or future receipt of a foreign currency, they can set up forward contracts to lock in the exchange rate.

• Forward contracts are often valued at $1 million or more, and are not normally used by consumers or small firms.

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• As with the case of spot rates, there is a bid/ask spread on forward rates.

• Forward rates may also contain a premium or discount.¤ If the forward rate exceeds the existing

spot rate, it contains a premium.¤ If the forward rate is less than the existing

spot rate, it contains a discount.

Forward Market

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• annualized forward premium/discount

= forward rate – spot rate 360

spot rate nwhere n is the number of days to maturity

• Example: Suppose £ spot rate = $1.681, 90-day £ forward rate =

$1.677.

$1.677 – $1.681 x 360 = – 0.95% $1.681 90

So, forward discount = 0.95%

Forward Market

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Forward Foreign Exchange Contract

Definition:

An agreement to exchange one

currency for another, where

• The exchange rate is fixed on the day of

the contract, but

• The actual exchange takes place on a pre-

determined date in the future

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Characteristics and Features of FX Forwards

• Available daily in major currencies in 30-, 90-,

and 180-day maturities

• Forwards are entered into “over the counter”

• Deliverable forwards: face amount of currency

is exchanged on settlement date

• Non-deliverable forwards: only the gain or loss

is exchanged

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• Contract terms specify: ¤ forward exchange rate¤ term¤ amount¤ ‘‘value date’’ (the day the forward contract expires)¤ locations for payment and delivery.

• The date on which the currency is actually

exchanged, the ‘‘settlement date,’’ is generally

two days after the value date of the contract.

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Forward Exchange Rates: “The Iron-Clad Law” • Forward exchange rates are different from spot rates, but

they are not a prediction of what the spot rate will be

when the deal settles!

The difference between the

forward exchange rate and the spot exchange rate

is the interest differential

between the two currencies

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Example 1: Hedging With an FX Forward

Hedged Item• Company must pay EUR

1,000,000 to a eurozone supplier in 3 months

• Spot rate HRK/EUR: 7.3000.• Treasurer believes HRK will

depreciate during next 3 months

¤ Exposure to FX risk: What will be exchange rate

HRK/EUR in three months??

Hedging Instrument• Bank buys 1,000,000 EUR

forward at forward rate of 7.3750

¤ FX risk: Company is protected against large adverse FX rate movements

If FX rate is unfavorable in 3 months (ie, > 7.3750), Company pays just 7.3750

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Hedged Item• Company must pay EUR

1,000,000 to a eurozone supplier in 3 months

• Spot rate HRK/EUR: 7.3000.• Treasurer believes HRK will

depreciate during next 3 months

Advantages of Hedge: Company knows its costs and

can plan its finances accordingly

Cost of the hedge is zero --• No money is exchanged at

inception of the forward FX agreement

Hedging Instrument• Bank buys 1,000,000 EUR

forward at forward rate of 7.3750

Disadvantage of Hedge: Company is still exposed to FX

risk if the HRK/EUR spot rate is less than 7.3750 in 3 months

Effect of hedge is same as buying EUR today and holding in an interest-

bearing account(Forward FX agreement is NOT a simple speculation)

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Unhedged Company

• If in 3 months, spot rate is 7.4500…

¤ Unhedged Company must pay:

7.45 x 1,000,000 = HRK 7,450,000

Effect of Hedging

• Hedged Company has already bought EUR forward

¤ Hedged Company will pay:

7.375 x 1,000,000 = HRK 7,375,000Money saved by

hedging: 7,450,000 – 7,375,000 = HRK 75,000

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Example 2: Deriving the Forward Exchange Rate

• The spot rate HRK/EUR is 7.3000

• A bank today sells a 3-month HRK/EUR forward to a company for a forward exchange rate of 7.3371

• How did the bank compute the forward rate?

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• Three month interest rates are:

¤ 1% on the euro¤ 3% on the kuna

• A company with EUR 1 million and a need for HRK in three months should be indifferent, financially speaking, as to whether it:

¤ Invests the EUR 1 million for 3 months at 1% and converts the euros (plus interest) into HRK at the end of this time, or

¤ Sells the EUR 1 million spot for HRK, and invests the HRK at 3% for 3 months

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Invest EUR 1 million at 1%for 3 months (91 days)

Interest earned EUR2,493.15

Value after 3 monthsEUR 1,002,493

Sell EUR 1 million spot at 7.30Buy HRK 7.3 million

Invest HRK for 3 months at 3%

Interest earned HRK55,358.33

(7.3 million x 3% x 91/360)

Value after 3 monthsHRK 7,355,358

OPTION 1 OPTION 2

Forward Exchange Rate: 7.3371

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• The forward premium/discount reflects the difference between the home interest rate and the foreign interest rate, so as to prevent arbitrage.

Forward Market

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• A non-deliverable forward contract (NDF) is a forward contract whereby there is no actual exchange of currencies. Instead, a net payment is made by one party to the other based on the contracted rate and the market rate on the day of settlement.

• Although NDFs do not involve actual delivery, they can effectively hedge expected foreign currency cash flows.

Forward Market

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Currency Futures Market

• Currency futures contracts specify a standard volume of a particular currency to be exchanged on a specific settlement date, typically the third Wednesdays in March, June, September, and December.

• They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

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• The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), on automated trading systems (e.g. GLOBEX), or over-the-counter.

• Participants in the currency futures market need to establish and maintain a margin when they take a position.

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Forward Markets Futures MarketsContract size Customized. Standardized.Delivery date Customized. Standardized.Participants Banks, brokers, Banks, brokers,

MNCs. Public MNCs. Qualifiedspeculation not public speculationencouraged. encouraged.

Security Compensating Small securitydeposit bank balances ordeposit required.

credit lines needed.


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Clearing Handled by Handled byoperation individual banks exchange

& brokers. clearinghouse.Daily

settlementsto market

prices.Marketplace Worldwide Central exchange

telephone floor with globalnetwork. communications.


Forward Markets Futures Markets

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Regulation Self-regulating. CommodityFutures Trading

Commission,National

FuturesAssociation.Liquidation Mostly settled by Mostly settled by

actual delivery. offset.Transaction Bank’s bid/ask Negotiated

Costsspread. brokerage fees.


Forward Markets Futures Markets

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• Normally, the price of a currency futures contract is similar to the forward rate for a given currency and settlement date, but differs from the spot rate when the interest rates on the two currencies differ.

• These relationships are enforced by the potential arbitrage activities that would occur otherwise.


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• Currency futures contracts have no credit risk since they are guaranteed by the exchange clearinghouse.

• To minimize its risk in such a guarantee, the exchange imposes margin requirements to cover fluctuations in the value of the contracts.


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• Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa.

• Currency futures may be purchased by MNCs to hedge foreign currency payables, or sold to hedge receivables.

• Holders of futures contracts can close out their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts


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• Most currency futures contracts are closed out before their settlement dates.

• Brokers who fulfill orders to buy or sell futures contracts earn a transaction or brokerage fee in the form of the bid/ask spread.


Documents

Forward Market