What is Forward market for currency ?
The forward market allows importers or exporters to fix, at the time of the contract, a price for the purchase or sale of a fixed amount of foreign currency for delivery and payment at a specified future time.
This allows to eliminate the future exchange rate fluctuations.
The forward contracts are executed in the terms on a future date (1, 3, 6, 9 and 12 months.)
How do we calculate forward rates ?
The forward exchange rate is calculated by adjusting the spot exchange rate (the rate in the market at the present moment.) by the ratio of interest rates of the same maturity for the 2 currencies.
e.g If S Rs55/$ and the Annualized Deposit rate in India = 12%, Euro Dollar deposit rate = 8%
then the 90 day forward of Rs/$ i.e. F90 Rs/$ = Rs55 * (1.03/1.02) = Rs 55.54/$
Note - The above equation complies to the Interest Rate Parity (IRP) principle i.e. Interest rate differentials must equal the difference between forward and spot rates.
Also we can derive the forward rates from the Purchasing Power Parity (PPP) principle i.e. The relative costs of living in two countries will not be affected by differences in their inflation rates. Instead, the different inflation rates in local currencies will be offset by changes in the exchange rate between the two currencies.
Dealers Bid Offer Rate.
Dealers quote 2 prices, rate to buy (bid) and rate to sell (offer) the base currency (often seen in indirect quote)
e.g. Bid - S Rs54/$ - Dealer buying $ will give Rs54 per $
e.g. Offer - S Rs50/$ - Dealer selling $ will accept Rs50 per $
Premium or discount in the spot rates will be subtracted or added respectively to calculate the Forward rates.
Hedging with Forward Contracts
A US importer knows on 1April he will need to pay Swiss supplier SF26,500 in one months time.
The importer can arrange a forward exchange contract with his bank on 1st April whereby the bank agrees to sell SF 26,500 to the importer @ SF2.6400/$.
Thus the importer knows that his cost of the transaction will be ~ $10,037.00
If spot rate in months time goes below 2.6400, i.e. the SF appreciates and the $ weakens, the importer has successfully protected himself as he has avoided paying more $ to obtain the SF as per the agreement of his forward contract.
If spot rate in months time goes above 2.6400, i.e. the $ appreciates and the SF weakens, the importer has lost his upside potential as he has pay more $ to obtain the SF as per the agreement of his forward contract than he would have to pay if he obtained the SF at the spot rate on end of the month.
Thus the forward contract with a fixed exchange rate removes upside potential and downward risk.
Speculation in Forward Contracts
Since Forward contracts enable you to lock into a future price and so speculate on the future spot rate for profit.
e.g Lets assume you have $100 with you. If current 3month forward contract is $0.009/Y and you know that spot rate in 3 months will be $0.008/Y (i.e Y appreciates and $ depreciates), you can enter the contract to sell Y on the expiry of contract.
i.e. On expiry, 1) buy the Y @$0.008
i.e. with $100 you will get Y12,500 and
2) sell Y @0.009 as per the fwd contract.
Hence you receive $112.5 selling Y. The overall profit is $12.5 with no cash outlay
Options and Forward Contracts
In this case the customer has the option to call for the performance of the contract at any date from the contract being made up to the future specified date.
The call must take place at some time, it cannot be avoided altogether
These are usually used when the customer is unsure of the exact date on which he will want to buy or sell the currency.
The forward market allows importers or exporters to fix, at the time of the contract, a price for the purchase or sale of a fixed amount of foreign currency for delivery and payment at a specified future time.
This allows to eliminate the future exchange rate fluctuations.
The forward contracts are executed in the terms on a future date (1, 3, 6, 9 and 12 months.)
How do we calculate forward rates ?
The forward exchange rate is calculated by adjusting the spot exchange rate (the rate in the market at the present moment.) by the ratio of interest rates of the same maturity for the 2 currencies.
e.g If S Rs55/$ and the Annualized Deposit rate in India = 12%, Euro Dollar deposit rate = 8%
then the 90 day forward of Rs/$ i.e. F90 Rs/$ = Rs55 * (1.03/1.02) = Rs 55.54/$
Note - The above equation complies to the Interest Rate Parity (IRP) principle i.e. Interest rate differentials must equal the difference between forward and spot rates.
Also we can derive the forward rates from the Purchasing Power Parity (PPP) principle i.e. The relative costs of living in two countries will not be affected by differences in their inflation rates. Instead, the different inflation rates in local currencies will be offset by changes in the exchange rate between the two currencies.
Dealers Bid Offer Rate.
Dealers quote 2 prices, rate to buy (bid) and rate to sell (offer) the base currency (often seen in indirect quote)
e.g. Bid - S Rs54/$ - Dealer buying $ will give Rs54 per $
e.g. Offer - S Rs50/$ - Dealer selling $ will accept Rs50 per $
Premium or discount in the spot rates will be subtracted or added respectively to calculate the Forward rates.
Hedging with Forward Contracts
A US importer knows on 1April he will need to pay Swiss supplier SF26,500 in one months time.
The importer can arrange a forward exchange contract with his bank on 1st April whereby the bank agrees to sell SF 26,500 to the importer @ SF2.6400/$.
Thus the importer knows that his cost of the transaction will be ~ $10,037.00
If spot rate in months time goes below 2.6400, i.e. the SF appreciates and the $ weakens, the importer has successfully protected himself as he has avoided paying more $ to obtain the SF as per the agreement of his forward contract.
If spot rate in months time goes above 2.6400, i.e. the $ appreciates and the SF weakens, the importer has lost his upside potential as he has pay more $ to obtain the SF as per the agreement of his forward contract than he would have to pay if he obtained the SF at the spot rate on end of the month.
Thus the forward contract with a fixed exchange rate removes upside potential and downward risk.
Speculation in Forward Contracts
Since Forward contracts enable you to lock into a future price and so speculate on the future spot rate for profit.
e.g Lets assume you have $100 with you. If current 3month forward contract is $0.009/Y and you know that spot rate in 3 months will be $0.008/Y (i.e Y appreciates and $ depreciates), you can enter the contract to sell Y on the expiry of contract.
i.e. On expiry, 1) buy the Y @$0.008
i.e. with $100 you will get Y12,500 and
2) sell Y @0.009 as per the fwd contract.
Hence you receive $112.5 selling Y. The overall profit is $12.5 with no cash outlay
Options and Forward Contracts
In this case the customer has the option to call for the performance of the contract at any date from the contract being made up to the future specified date.
The call must take place at some time, it cannot be avoided altogether
These are usually used when the customer is unsure of the exact date on which he will want to buy or sell the currency.
No comments:
Post a Comment