FX Forwards can be an extremely useful tool for businesses looking to hedge their FX exposure. In previous articles, we have walked through the benefits of employing in FX forwards in such a capacity. However, there is often some confusion, main among business encountering FX forwards for the first time, as to what these contracts are and how they are prices.
What are FX Forwards?
Put simply, FX Forwards are contracts which establish an agreement to exchange a specified amount of currency at a pre-determined future date. In terms of the functionality of these contracts; the exchange rate for the transaction is agreed at the time the contract is entered (known as the “trade date” with the settlement date taking place a few days later. The time which elapses between the trade date and settlement date is referred to as the “settlement convention”. There is also a further settlement convention which elapses after the maturity date of the contract, allowing for the exchange of currencies to take place.
How does an FX Forward transaction differ from a Spot market transaction?
The main difference is that the spot market transaction operates with immediate delivery. However, an FX Forward transaction agrees on delivery at a future date and as such carries different pricing to the spot market. The difference in pricing is due to the relevant interest rate on the transaction.
There is a common misconception among those first encountering these contracts that FX Forwards denotes the price at which a currency pair is expected to be trading in the future. However, this is not the case. FX Forwards are merely a function of the relevant interest rates and the duration of the contract and in no way reflect any expectations of where the price is headed.
So How are FX Forwards Priced?
There are some lovely technical formulas which we will not bore you within this article, in the interest of everyone’s sanity. Instead, here are the key takeaways regarding FX Forwards pricing.
When you buy an FX Forward, the accrual of interest on the currency purchased, over the currency sold, can lead to profit. This profit can then be increased if the exchange of currency at the maturity date of the transaction is advantageous. To protect against what would essentially be “risk-free profit”, FX Forwards carry a different price which essentially considers the interest rates applicable to the currency deal in question.
FX Forward Pricing Example
For example, let’s consider the difference in hypothetical pricing of a EURUSD 1.30 in the spot market and EURUSD 1.32 for a 3 month Forward contract.
If the ECB headline rate was 2.5% (per annum) and the Fed’s headline rate was 5% (per annum), then the forward price would be 1.3082. This accounts for the 82 USD which would be accrued in interest over the period.
Similarly, if the short-term interest rate differential is negative (e.g the interest rate of the term currency is lower than the base currency) then the FX Forward will trade at a discount to the spot price, this is to mitigate against the intrinsic loss which will be incurred due to the interest rate differential.
What Are the Risks With FX Forwards?
While FX Forwards are certainly an extremely useful tool for businesses looking to hedge their FX exposure, they are not without risk, as with all transactions and instruments in financial. With FX Forwards, the main threat is credit risk. As the transaction does not undergo immediate settlement (as with spot market transactions), there is the risk of default. If the counterparty to the transaction is not able to fulfil their obligation (default) at the maturity date, the initial party might lose part or all of the value of their transaction.
Exchange Rate & Interest Rate Risk
It is also worth considering that as FX Forwards lock in an exchange rate and are calculated off the spot value of the time ( in conjunction with the relevant interest rate parity and the duration of the contract) the client essentially loses the ability to secure more advantageous terms. This essentially describes interest rate risk and exchange rate risk.
For example, if the interest rates involved are altered during the course of the contract, the client is unable to benefit from any advantageous shift in rates. Similarly, if the exchange rate shifts materially, again, the client is unable to benefit from any advantageous moves in the underlying spot price. It is important for corporate treasuries to assess these risks when it comes to employing FX Forwards as part of their currency hedging.