FX Forwards

Derivatives_Novice_Notes_Week26: FX Forwards

FX Forwards (Foreign Exchange Forwards) are OTC derivatives contracts that allow two parties to exchange currencies at a future date for a specified exchange rate. The exchange rate is determined at the time of the contract, and the actual exchange of currencies occurs on the agreed-upon future date.

FX Forward contracts are primarily utilized to hedge against currency exchange rate risk. They protect the buyer or seller against unfavorable currency exchange rate occurrences that may arise between when a trade is contracted and when the deal is actually made. Unlike spot foreign exchange transactions, which settle within two business days, FX forwards allow the parties to lock in a future exchange rate for a transaction that will occur later.

Key Features of FX Forwards

• Customizable Contracts: FX forwards are customizable contracts, meaning the parties can set the amount of currency to be exchanged, the currencies involved, and the settlement date. This flexibility allows them to be tailored to the involved parties' specific needs and makes them useful for businesses and investors with specific hedging or speculative needs.
• Agreed-upon Exchange Rate: At the time the contract is signed the exchange rate for the future transaction is agreed upon upfront, regardless of the market exchange rate at the time of settlement. This rate is often referred to as the forward rate. This rate is typically based on the spot exchange rate at the time. The agreed rate eliminates the risk of exchange rate fluctuations between the signing and settlement dates.
• No Exchange of Principal Until Maturity: Unlike spot transactions, where the currencies are exchanged immediately, in an FX forward, the currencies are exchanged only at the agreed-upon future date.
• No Initial Payment: Unlike other derivatives like futures or options, there is no upfront payment required to enter into an FX forward contract. The transaction will settle on the maturity date.
• Settlement: On the settlement date (also called the maturity date), the agreed-upon currencies are exchanged between the two parties at the forward rate. The transaction can be settled either physically (by delivering the currencies) or in cash (by exchanging the equivalent value). It can range from a few days to several years into the future.

Benefits of FX Forwards

• Hedging Currency Risk: FX forwards allow businesses to lock in exchange rates for future transactions, helping them protect against unfavorable currency fluctuations. This is particularly useful for companies engaged in international trade or those with future foreign currency obligations.
• Speculation: Traders may also use FX forwards to speculate on the direction of exchange rates. If a trader believes that the currency will appreciate in the future, they might enter into a forward contract to lock in a favorable exchange rate today, aiming to profit from the difference between the agreed-upon forward rate and the spot rate at settlement.
• Arbitrage: Arbitrageurs may use FX forwards to exploit differences between the spot exchange rate and the forward rate in different markets.

How does FX Forward work?

Let us understand the end-to-end cycle of an FX Forward trade using an example where Unilever and BMW enter into an FX Forward contract, and Barclays facilitates the contract.

Use Case Details:

• Unilever (Buyer), is a UK-based company that imports goods from the Eurozone, has to pay €1,000,000 for raw materials in 6 months. Unilever is concerned that the GBP might weaken against the EUR, increasing the payment cost.
• BMW (Seller), is a German company that sells high-end automobiles to the UK. BMW expects a payment of GBP in 6 months and is worried that the GBP might appreciate, making their expected GBP receipt less valuable in EUR.
• Barclays acts as the broker to facilitate the FX forward contract, helping both parties lock in an exchange rate and manage their currency exposure.

Steps Involved in FX Forwards Trade Transaction

Initial Agreement

• Unilever (Buyer) contacts Barclays to enter into an FX forward contract concerning that the GBP will weaken, and they would need to spend more GBP to obtain the euros. They need to buy €1,000,000 in 6 months to pay BMW for automobile parts.
• BMW (Seller) contacts Barclays as well, wanting to lock in an exchange rate for the €1,000,000 they expect to receive in 6 months from Unilever. BMW is worried that the GBP will appreciate, reducing the amount of EUR they would receive for the same amount of GBP.
• Barclays facilitates the agreement between Unilever and BMW, as both parties are looking for the same trade.

Determining the Forward Rate

Barclays uses the interest rate parity (IRP) formula to calculate the forward rate for a contract that will mature in 6 months.

Interest Rate Parity is a concept of foreign exchange markets that explains the relationship between the interest rates of two countries and the exchange rates between their currencies. It states that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate. In other words, the expected return on investments in different currencies should be the same when considering both the exchange rate and interest rate differential.

Spot Rate (GBP/EUR): The current exchange rate between GBP and EUR is 1 GBP = 1.1500 EUR(Assumption).

Interest Rates:

• Interest rate for GBP (UK): 4% per annum
• Interest rate for EUR (Eurozone): 2% per annum
• The formula for the Forward rate is:

Forward Rate = Spot Rate*[ (1+Interest Rate of Currency A) / (1+Interest Rate of CurrencyB)]

• => Forward Rate = 1.15 * [ (1+0.04/2) / (1+0.02/) ]
• => Forward Rate = 1.15 * [1.02/1.01]
• => Forward Rate = 1.15 * 1.0099
• => Forward Rate = ~ 1.1515

The Forward Rate agreed upon by both parties is 1 GBP = 1.1515 EUR for settlement in 6 months.

Calculating the amount of €1,000,000

= > €1,000,000 /1.1515 =? GBP 869,565.22

Thus? €1,000,000 as per forward rate is equivalent to GBP 869,565.22

Trade Execution

• Unilever agrees to buy €1,000,000 in 6 months for GBP 869,565.22 (calculated as €1,000,000 / 1.1515).
• BMW agrees to sell €1,000,000 for the same amount, GBP 869,565.22, which they will receive at the agreed forward rate in 6 months.
• Barclays finalizes the deal by confirming the forward rate and documenting the agreement between both parties.

Settlement

On the settlement date, 6 months later:

• Unilever sends GBP 869,565.22 to BMW.
• BMW sends €1,000,000 to Unilever.

The exchange of currencies takes place at the agreed forward rate of 1 GBP = 1.1515 EUR, regardless of the actual spot rate at that time.

Payment and Delivery

• Hypothetically if the market spot rate at settlement is 1 GBP = 1.1200 EUR, Unilever benefits from having locked in a better rate, as they would have needed to spend GBP 892,857.14 (instead of GBP 869,565.22) to buy €1,000,000 at the prevailing spot rate.
• On the other hand, BMW is protected from the potential appreciation of the GBP, as they still receive GBP 869,565.22 despite the GBP strengthening.

How are FX Forwards different from FX Futures, FX Options, and FX Swaps?

FX Forwards, FX Swaps, FX Futures, and FX Options are all Derivatives instruments used to manage or speculate on currency exchange rate movements, but they differ in their structure, trading mechanisms, and applications. Here’s a breakdown of the key differences between these instruments.

That is all for today. Thank You!