Foreign Exchange forward contracts can be incredibly useful for businesses wanting to hedge their FX exposure. They are contracts which allow you to lock in exchange rates for future transactions, shielding you from adverse currency movements.
Confusion can arise when placing a trade for the first time as the FX rate quoted is different from the current rate. This blog will debunk the technique used to price FX forward contracts.
What are FX Forward contracts?
The “official” definition is that a foreign exchange forward contract is an agreement between two parties to exchange a specified amount of one currency for another at a future date, with an agreed-upon exchange rate. Put simply, you agree to buy a currency at some point in the future at a set rate, which you must legally settle on the agreed date.
What is the difference between a Spot FX trade and an FX forward?
A spot trade will settle 2 days after the transaction date and is therefore traded in the spot market. A forward trade will settle on a future date, it could be 3 days or up to 2 years in the future.
A common misunderstanding is that forwards are traded and priced like spot trades, meaning they are based on the performance of the currency market and move in line with economic fundamentals however this is not the case.
How are FX Forwards priced?
The difference between the FX rate now and the FX rate in the future is based on the interest rate difference between the two currencies. The market ensures this is the case to minimise arbitrage opportunities.
To explain this in layman’s terms, if a business wanted to sell GBP to buy USD and the interest base rate in the UK was very low at the time and the interest base rate in the US was high, it would make commercial sense to sell the pounds and buy dollars as quickly as possible to earn additional interest on the cash by holding it in dollars. This would allow traders to earn unlimited risk-free profit and encourage anyone who has pounds to sell them into USD to earn as much interest as possible.
Forward points prevent this from happening, as the positive interest rate differential means that if the dollars were bought today, or in 3 months, the trader would not make any more money. The forward points, which are calculated as the difference between the interest rates in the UK and the US, would ensure that the amount of USD received was equivalent to buying the USD now and holding it in an interest-bearing account.
FX Forward Rate = Spot rate + Forward Points
What is the risk?
Currency Markets
The pricing of forwards is agreed at a point in time, and therefore when the trades settle they may be “in the money” or “out of the money” depending on how the currency markets have changed since the original trade was booked. The further in advance the trade was booked, the bigger the currency risk is.
Interest Rates
Interest rates may also have moved in that time, meaning if the interest rate in the buying currency increased, interest income may have been lost.
Credit Risk
The forward contract is a legally binding transaction with a liquidity provider. If that provider does not fulfil their obligation to settle the trade on the settlement date then the business is again exposed to the currency of the underlying transaction.
A Bit on Interest Rates
Interest rates themselves are based on economic fundamentals and how the central bank forecasters expect the economy to perform.
When considering the monetary policy for the currency, interest rates are increased and decreased predominantly to manage inflation and currency flow into and out of the country.
When interest rates are higher compared to other currencies, this creates a weak currency environment which helps a country’s exports gain market share as its goods will appear less expensive compared to other countries which have a strong currency.
A country which has a strong currency will benefit from cheaper imports as the currency has more worth and can buy more of other currencies.
Wrap it Up
Forward contracts are popular for a reason, they are a cheap and accessible way to manage currency risk. Accessing the FX market has never been easier with so many great providers in the industry. If you’re keen to learn more or have any questions about this content, leave a comment below or get in touch via enquiries@treasuryedge.co.uk.