Forward Transactions

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Information about Forward Transactions

Published on July 23, 2008

Author: sukumarnandi


FORWARDTRANSACTIONS Sukumar NandiIndian Institute of Management Lucknow : FORWARDTRANSACTIONS Sukumar NandiIndian Institute of Management Lucknow Forward Transactions : Forward Transactions In foreign exchange market forward transactions are the most widespread hedging instrument for foreign currency positions A Forward transaction consists of a commitment to buy or sell a specific amount of foreign currency at a later date or within a specific time period and at an exchange rate stipulated at the time the transaction is concluded. The delivery or receipt of the currency takes place on the agreed upon value date. In contrast to spot transactions, the commitment of a forward transaction (conclusion of the agreement) and the fulfillment (delivery and payment) are clearly separate in terms of time. Slide 3: As in the case of spot transactions, forward transactions in all of the major currencies may be concluded by telephone. The maximum period for most of currencies is 12 months, whereas upto 5 years may be granted for the principal currencies. The most common periods are 1,3 and 6 months. However, so-called broken dates of, say, 9 or 43 days are possible. A forward transaction cannot be cancelled. On the other hand, it can be closed out at any time by the repurchase or sale of the foreign currency amount on the value date originally agreed upon. Possible losses or gains are then realized on this date. Normally, the forward price and spot price of a currency differ. If the forward price is higher than the spot price, we speak of forward premium, and if it is lower, we speak of a forward discount. These premiums and discounts reflect the interest rate differentials between the currencies in the Euromarket Slide 4: The following chart shows the relationships Forward Discount Forward Premium a b Slide 5: What is the reason for the difference between the forward rates and spot rates ? If a foreign currency with higher interest rates is not sold on a spot basis but only forward, the seller enjoys an interest rate advantage during the period in question. The buyer, however, is at a disadvantage due to the fact that he must wait until he can invest his funds in the currency enjoying the higher interest rates. Therefore, the interest rate disadvantage is offset by the price discount. Slide 6: Calculation of the forward rate can be broken into several steps : The basic operation is as follows : spot rate +/- premium/discounts = forward rate The forward discount or premium is calculated by means of the following general formulaspot rate x interest rate differential x term in days 360 x 100 This formula does not take into account the currency risk coupled with the interest rates of the traded currency. In order to hedge this risk as well, the formula must be expanded to :Spot rate x interest rate differential x term in days360 x 100 + (foreign currency interest rate x term) Slide 7: From these formulas the following conclusions can be drawn : the discount or premium is in direct proportion to the term (a long term = a large premium or discount) It is not the level of the interest rates of the currencies involved but the difference in the interest rates that determines the discounts the premiums the forward rates are calculated mathematically; the formula does not contain any estimates. Slide 8: If a customer sells the bank US dollars against Swiss francs 6 months forward, the following transactions must be carried out by the bank in order to cover all of the currency and interest rate risk : Sale of US dollars for Swiss francs at the US$/S Fr. spot bid price (counter party buys US dollars and pays Swiss francs for them). The US dollars sold spot must be borrowed on the Euromarket at the offered rate for 6-month Euro-US dollars until delivery by the customer (in 6 months). The Swiss francs from the spot transaction will be invested on the Euromarket at the bid rate for 6-month Euro-Swiss francs until the customer’s Swiss-franc account is credited (in 6 months). The interest in US dollars due in 6 months must be covered forward. Slide 9: The US$/S Fr. Forward rate is calculated as follows : Discount Premium bid rate = Bid spot rate x (bid SFr. Eurorate - offered US$ Eurorate) x term 360 x 100 + (offered US$ Eurorate x term) Discount/premium offered rate : Offered spot rate x (Off. SFR. Eurorate - bid US$ Eurorate) x term 360 x 100 + (bid US$ Eurorate x term) Since a forward transaction is settled in the future, the bank requires a guarantee, which is initially stipulated in a percentage of the contract amount but is adjusted to adverse market developments. This collateral - called the margin - serves, in the event of non-fulfillment, to cover any losses that may occur by closing out. Slide 10: The customer is free to select the form of collateral to be provided : In the case of private customers, the collateral usually takes the form of pledged assets, such as securities, precious metals, account balances, deposits, etc. The pledging of these assets does not impair their earnings power. In the case of corporate customers, a special credit line - called margin limit - may be opened for this purpose. The annual presentatin of the company’s balance sheet and income statement is generally required. Slide 11: 1.1 Fixed Forward Date Most forward transactions are concluded on the basis of a fixed forward date. In professional trading, the term outright transaction is also used. An outright transaction is often used in connection with export or import operations. Export Inc. is delivering capital goods to the United States. It expects a payment of US$ 100,000 - in 6 months. In order to avoid the exchange rate risk, Export Inc. today sells its bank US dollars for the value date when it expects to receive the US dollars. Assumption :Spot rate US$/S Fr : 1.5520 - 40Interest rate for 6-month Euro-US$ 6.25 - 6.50 %p.a.Interest rate for 6-month Euro-S Fr 3.75 - 4% p.a.Term 180 days Slide 12: Using the formula, the forward rate, including interest rate hedging (bid rate of the bank) is calculated as follows :1.5520 x (-2.75) x 180 = SFr. 0.0207 discount360 x 100 + (6.50 x 180) US $/SFr. spot rate SFr. 1.5520- discount SFr. 0.02076-month US$/SFr. forward rate SFr. 1.5313 When the US dollar amount is paid in 6 months time. Export Inc. will receive SFr. 1.5313 per US$ 1, or SFr. 153.130. The exchange rate hedging costs Export Inc. SFr. 0.0207 per US$ 1. Slide 13: Import Inc. owes FI. 35,000 - for consumer goods it has purchased. The company wants to calculate and hedge the foreign currency payments falling due in 3 months. To accomplish this it concludes today a forward purchase with its bank that is due in 3 months. Assumption :Spot rate FR./S Fr : 74.10 - 74.20Interest rate for 3-month Euro-FI. 5.25 - 5.50 % p.a.Interest rate for 6-month Euro-S Fr 3.875 - 4.125 %p.a.Term : 90 days Slide 14: The forward rate (bank’s offered price) is thus calculated as follows :74.20 x (–1.125) x 90 = = SFr. 0.21 discount360 x 100 + (5.25 x 90) FI./SFr. spot rate SFr. 74.20- discount SFr. 0.213-month FI./SFr. forward rate SFr. 73.99 On the payment date in 3 months, Import Inc. must pay SFr. 73.99 per FI. 100, or a total of SFr. 258,965. In terms of spot rate, Import Inc. saved SFr. 0.21 per FI. 100. Slide 15: 1.2 Variable Maturity Forward transactions with variable maturities are not new types of transactions or means of hedging but a variant of conventional foreign exchange forward operations. The requirements of the exporter and the importer relating to the maturity date can then be given special consideration. There may be many reasons why the date the payment is received or made cannot be fixed exactly, such as delays in government approval procedures, delivery postponements, unknown dates for presenting documents and so on. In order to initiate forward transactions as a hedging instrument in these cases and, above all, to carry them out simply, the banks offer forward transactions with variable maturities. Forward transactions with variable maturities are sometimes erroneously called forward options, although they have nothing in common with an option. The advantage of variable maturity is that the customer is free to select a value date within the term stipulated at the time the transaction is concluded. This means that the hedging costs are already known at the outset of the transaction. Slide 16: Import Inc. purchases consumer goods in France for FF 1 million on March 28 to be delivered at the earliest on April 28 (in 31 days) and at the latest on May 28 (61 days), payable immediately upon receipt of goods. Import Inc. wants to hedge the exchange rate risk and to buy the French francs through a forward transaction with variable maturity (April 28 to May 28) Assumption : Spot rate FF/S Fr : 23.97 - 00 Interest rate for Euro-FF 8.75 - 9% p.a.(maturities 1 and 2 months) Interest rate for 1-month Euro-S Fr 3.75 - 4% p.a. Interest rate for 2-month Euro-S Fr 3.625 - 3.875 % p.a. Slide 17: As seen, French francs carry a higher interest rate than Swiss francs. This means that the forward rate of the French franc is fixed at a discount. The bank must be aware that import Inc. could draw the French francs already after 1 month and therefore hedges its exposure as of this date. The fixed forward rate is thus no longer affected by changes in the interest rates of the two currencies which could play a role in the case of hedging via a fixed forward transaction if the latter is renewed or drawn early. Slide 18: The variable forward rate is calculated as follows :24.00 x (-4.75) x 31 = SFr. -0.10 discount360 x 100 + (8.75 x 31)Spot rate FF/SFr. SFr. 24.00- discount SFr. 0.10Forward rate variable 28.4 - 28.5 SFr. 23.90 At the time Import Inc. draws the French francs, i.e., between April 28 and May 28, it thus will have to pay SFr. 23.90 per FF 100, or a total of SFr. 239,000 - Compared with the current spot rate it will have saved SFr. 0.10 per FF 100.

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