FORWARD EXCHANGE

Q-1 WHAT IS FORWARD FOREIGN EXCHANGE MARKET?

ANSWER:

A forward market is an over-the-counter marketplace that sets the price of

a financial instrument or asset for future delivery. Forward markets are used for
trading a range of instruments, but the term is primarily used with reference to the
foreign exchange market. It can also it can also apply to markets for securities and
interest rates as well as commodities.

EXPLANATION

A forward market leads to the creation of forward contracts. While forward

contracts, like futures contracts, may be used for both hedging and speculation,
there are some notable differences between the two. Forward contracts can be
customized to fit a customer's requirements, while futures contracts have
standardized features in terms of their contract size and maturity. Forwards are
executed between banks or between a bank and a customer; futures are done on an
exchange, which is a party to the transaction. The flexibility of forwards contributes to
their attractiveness in the foreign exchange market.

Pricing

Prices in the forward market are interest-rate based. In the foreign exchange
market, the forward price is derived from the interest rate differential between the two
currencies, which is applied over the period from the transaction date to the
settlement date of the contract. In interest rate forwards, the price is based on the
yield curve to maturity.

Foreign Exchange Forwards

Interbank forward foreign exchange markets are priced and executed as

swaps. This means that currency A is purchased vs. currency B for delivery on the
spot date at the spot rate in the market at the time the transaction is executed. At
maturity, currency A is sold vs. currency B at the original spot rate plus or minus the
forward points; this price is set when the swap is initiated. The interbank market
usually trades for straight dates, such as a week or a month from the spot date.
Three- and six-month maturities are among the most common, while the market is
less liquid beyond 12 months. Amounts are commonly $25 million or more and can
range into the billions.

Customers, both corporations and financial institutions such as hedge funds

and mutual funds, can execute forwards with a bank counter-party either as a swap
or an outright transaction. In an outright forward, currency A is bought vs. currency B
for delivery on the maturity date, which can be any business day beyond the spot
date. The price is again the spot rate plus or minus the forward points, but no money
changes hands until the maturity date. Outright forwards are often for odd dates and
amounts; they can be for any size.
The most commonly traded currencies in the forward market are the same as on the
spot market: EUR/USD, USD/JPY and GBP/USD.

Forward Exchange Contract

A forward exchange contract is a special type of

foreign currency transaction. Forward contracts are agreements between two parties
to exchange two designated currencies at a specific time in the future. These
contracts always take place on a date after the date that the spot contract settles and
are used to protect the buyer from fluctuations in currency prices.

EXPLANATION
Forward contracts are not traded on exchanges, and standard amounts of
currency are not traded in these agreements. They cannot be cancelled except by
the mutual agreement of both parties involved. The parties involved in the contract
are generally interested in hedging a foreign exchange position or taking
a speculative position. The contract's rate of exchange is fixed and specified for a
specific date in the future and allows the parties involved to better budget for future
financial projects and known in advance precisely what their income or costs from
the transaction will be at the specified future date. The nature of forward exchange
contracts protects both parties from unexpected or adverse movements in the
currencies' future spot rates.

Generally, forward exchange rates for most currency pairs can be obtained for
up to 12 months in the future. There are four pairs of currencies known as the "major
pairs." These are the U.S. dollar and euros; the U.S. dollar and Japanese yen; the
U.S. dollar and the British pound sterling; and the U.S. dollar and the Swiss franc.
For these four pairs, exchange rates for time period of up to 10 years can be
obtained. Contract times as short as a few days are also available from many
providers. Although a contract can be customized, most entities won't see the full
benefit of a forward exchange contract unless setting a minimum contract amount at
$30,000.

Forward Exchange Calculation Example

The forward exchange rate for a contract can be calculated using four variables:

S = the current spot rate of the currency pair

r(d) = the domestic currency interest rate

r(f) = the foreign currency interest rate

t = time of contract in days

The formula for the forward exchange rate would be:

Forward rate = S x (1 + r(d) x (t / 360)) / (1 + r(f) x (t / 360))

For example, assume that the U.S. dollar and Canadian dollar spot rate is 1.3122.
The U.S. three-month rate is 0.75%, and the Canadian three-month rate is 0.25%.
The three-month USD/CAD forward exchange contract rate would be calculated as:

Three-month forward rate = 1.3122 x (1 + 0.75% * (90 / 360)) / (1 + 0.25% * (90 /

360)) = 1.3122 x (1.0019 / 1.0006) = 1.3138

Currency Forward

A binding contract in the foreign exchange market that locks in the exchange
rate for the purchase or sale of a currency on a future date. A currency forward is
essentially a hedging tool that does not involve any upfront payment. The other
major benefit of a currency forward is that it can be tailored to a particular amount
and delivery period, unlike standardized currency futures. Currency forward
settlement can either be on a cash or a delivery basis, provided that the option is
mutually acceptable and has been specified beforehand in the contract. Currency
forwards are over-the-counter (OTC) instruments, as they do not trade on a
centralized exchange. Also known as an “outright forward.”

EXPLANATION

Unlike other hedging mechanisms such as currency futures and options

contracts – which require an upfront payment for margin requirements and premium
payments, respectively – currency forwards typically do not require an upfront
payment when used by large corporations and banks. However, a currency forward
has little flexibility and represents a binding obligation, which means that the contract
buyer or seller cannot walk away if the “locked in” rate eventually proves to be
adverse. Therefore, to compensate for the risk of non-delivery or non-
settlement, financial institutions that deal in currency forwards may require a deposit
from retail investors or smaller firms with whom they do not have a business
relationship.

The mechanism for determining a currency forward rate is straightforward,

and depends on interest rate differentials for the currency pair (assuming both
currencies are freely traded on the forex market). For example, assume a
current spot rate for the Canadian dollar of US$1 = C$1.0500, a one-year interest
rate for Canadian dollars of 3%, and one-year interest rate for US dollars of 1.5%.
After one year, based on interest rate parity, US$1 plus interest at 1.5% would be
equivalent to C$1.0500 plus interest at 3%.

Or, US$1 (1 + 0.015) = C$1.0500 x (1 + 0.03).

So US$1.015 = C$1.0815, or US$1 = C$1.0655.

The one-year forward rate in this instance is thus US$ = C$1.0655. Note that
because the Canadian dollar has a higher interest rate than the US dollar, it trades at
a forward discount to the greenback. As well, the actual spot rate of the Canadian
dollar one year from now has no correlation on the one-year forward rate at present.
The currency forward rate is merely based on interest rate differentials, and does not
incorporate investors’ expectations of where the actual exchange rate may be in the
future.

How does a currency forward work as a hedging mechanism? Assume a Canadian

export company is selling US$1 million worth of goods to a U.S. company and
expects to receive the export proceeds a year from now. The exporter is concerned
that the Canadian dollar may have strengthened from its current rate (of 1.0500) a
year from now, which means that it would receive fewer Canadian dollars per US
dollar. The Canadian exporter therefore enters into a forward contract to sell $1
million a year from now at the forward rate of US$1 = C$1.0655.

If a year from now, the spot rate is US$1 = C$1.0300 – which means that the C$ has
appreciated as the exporter had anticipated – by locking in the forward rate, the
exporter has benefited to the tune of C$35,500 (by selling the US$1 million at
C$1.0655, rather than at the spot rate of C$1.0300). On the other hand, if the spot
rate a year from now is C$1.0800 (i.e. the C$ weakened contrary to the exporter’s
expectations), the exporter has a notional loss of C$14,500.
Q-2 FORWARD PREMIUME AND DISCOUNT?
ANSWER:
The equilibrium that results from the relationship between forward and spot
exchange rates within the context of covered interest rate parity is responsible for
eliminating or correcting for market inefficiencies that would create potential for
arbitrage profits. As such, arbitrage opportunities are fleeting. In order for this
equilibrium to hold under differences in interest rates between two countries, the
forward exchange rate must generally differ from the spot exchange rate, such that a
no-arbitrage condition is sustained. Therefore, the forward rate is said to contain a
premium or discount, reflecting the interest rate differential between two countries.
The following equations demonstrate how the forward premium or discount is
calculated.

What is a 'Forward Discount?'

A forward discount, in a foreign exchange situation, is where the domestic

current spot exchange rate is trading at a higher level than the current
domestic futures spot rate for a maturity period. A forward discount is an indication
by the market that the current domestic exchange rate is going to depreciate in value
against another currency.

EXPLANATION

A forward discount means the market expects the domestic currency to

depreciate against another currency, but that is not to say that will happen. Although
the forward expectation's theory of exchange rates states this is the case, the theory
does not always hold.

What is a 'Forward Premium?'

A forward premium occurs when dealing with foreign exchange (FX); it is a

situation where the spot futures exchange rate, with respect to the domestic
currency, is trading at a higher spot exchange rate then it is currently. A forward
premium is frequently measured as the difference between the current spot rate and
the forward rate, but any expected future exchange rate suffices.

EXPLANATION

A forward premium is frequently measured as the difference between the

current spot rate and the forward rate, so it is reasonable to assume that the future
spot rate will be equal to the current futures rate. According to the forward
expectation's theory of exchange rates, the current spot futures rate will be the future
spot rate. This theory is routed in empirical studies and is a reasonable assumption
to make over a long-term time horizon.
Forward Rate Premium Calculation

To calculate the forward premium on a currency, you first must understand

covered interest parity and calculate the forward rate. Covered interest rate parity is
a condition where the spot and forward exchange rates between two currencies are
in equilibrium with the two countries' interest rates, preventing any arbitrage
opportunities. The formula for covered interest rate parity includes four variables:

S = the current spot exchange rate

F = the current forward exchange rate

i(d) = the domestic interest rate

i(f) = the foreign interest rate

The formula is: (1 + i(d) = S / F x (1 + i(f)

This equation can then be rearranged to solve for the forward exchange rate, F. It
appears as: F = S x (1 + i(f)) / (1 + i(d))

As an example, assume the current U.S. dollar to euro exchange rate is $1.1365.
The domestic interest rate, or the U.S. rate is 5%, and the foreign interest rate is
4.75%. Plugging the values into the equation results in: F = $1.1365 x (1.05 / 1.0475)
= $1.1392

The forward rate relates to the spot rate by a premium or discount, which is shown in
the following relationship: F = S x (1 + x), where z is the current premium or discount.
Rearranging the formula, the forward premium, or discount if the result is negative, is
calculated as: x = F / S - 1

However, since premiums are quoted as annualized percentages, the formula must
take into account the number of days the contract stipulates. The formula is then
adjusted to: x = (F / S - 1) x (360 / d), where d is the number of days.

Back to the example, assume the calculated forward rate is for a six-month forward
for the euro versus the dollar, deliverable in 30 days. In this example, the forward
premium is: x = ($1.1392 / $1.1365 - 1) x (360 / 30) = 2.851%

The result means the euro is trading at a 2.851% premium to the dollar for delivery in
30 days.