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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Forward Market
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.

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Forward Market
annualized forward premium/discount
forward rate spot rate 360
spot rate n
where 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%

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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 predetermined 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
6

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Characteristics and Features of

FX Forwards
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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Characteristics and Features of

FX Forwards
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
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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

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

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Example 1: Hedging
With an FX Forward
Unhedged Company
If in 3 months, spot
rate is 7.4500

Effect of Hedging
Hedged Company has
already bought EUR
forward

Unhedged Company
must pay:
7.45 x 1,000,000 =
HRK 7,450,000

Hedged Company will pay:

7.375 x 1,000,000 = HRK
7,375,000

Money 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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Example 2: Deriving the

Forward Exchange Rate
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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Example 2: Deriving the

Forward Exchange Rate
OPTION 1

OPTION 2

Invest EUR 1 million at 1%

for 3 months (91 days)

Sell EUR 1 million spot at 7.30

Buy HRK 7.3 million
Invest HRK for 3 months at 3%

Interest earned EUR

2,493.15

Interest earned HRK

55,358.33
(7.3 million x 3% x 91/360)

Value after 3 months

EUR 1,002,493

Value after 3 months

HRK 7,355,358

Forward Exchange Rate: 7.3371

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

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Forward Market
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.
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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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Currency Futures Market

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 overthe-counter.
Participants in the currency futures
market need to establish and maintain a
margin when they take a position.
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Currency Futures Market

Forward Markets Futures Markets
Contract size Customized. Standardized.
Delivery date Customized. Standardized.
Participants Banks, brokers, Banks, brokers,
MNCs. Public MNCs. Qualified
speculation not public speculation
encouraged. encouraged.
Security Compensating Small security
deposit bank balances ordeposit required.
credit lines needed.

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Currency Futures Market

Clearing
operation

Forward Markets Futures Markets

Handled by
Handled by
individual banks
exchange
& brokers.
clearinghouse.
Daily

settlements
to market
Marketplace Worldwide Central exchange
prices.
telephone floor with global
network.communications.

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Currency Futures Market

Regulation

Forward Markets
Self-regulating.

Futures Markets
Commodity
Futures Trading
Commission,
National

Futures
Association.
Liquidation Mostly settled by Mostly settled
by
actual delivery. offset.
Transaction Banks bid/ask Negotiated
Costsspread. brokerage fees.

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Currency Futures Market

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 Market

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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Currency Futures Market

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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Currency Futures Market

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.

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