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Forwards, Ndf's and Swap

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Forwards, Ndf's and Swap FORWARDS, NDF’S AND SWAP Ivan O. Asensio, Bank of America Global Corporate and Investment Bank THE FORWARD CONTRACT ~ In plain language, a forward contract is a commitment today to conduct business sometime in the future. It is a very simple concept, but an important one since forwards are often the first products used by companies and remain a principal risk management product for many. Economically it provides the perfect hedge. Parties can lock in a price today and forget about it. They are guaranteed execution at that particular level, regardless of subsequent market fluctuations. The parties who enter of a foreign exchange forward agree to exchange one currency for another on a future date, at a specified rate of exchange. It is very similar to a spot transaction, with the difference being that the commitment date occurs further in the future. The cash exchange in a spot transaction occurs typically in two days whereas a forward exchange takes place beyond the spot delivery date. Illustrated in Exhibit One (below) is an example comparing the sale of 100 million JPY spot vs. 100 million JPY forward. Exhibit One: Spot and Forward Transactions Spot Transaction FWD Transaction COMPANY COMPANY Spot Transaction 1Y Fwd Transaction 1/1/XX 1/1/XX 100 million JPY 100 million JPY @ 129.00 @ 122.62 $775,194 USD $815,528 USD Delivery on 1/3/XX Delivery on 12/31/XX Unless otherwise noted, the forward agreement entails physical delivery of the specific currencies. Agreements can also be structured with net cash settlement, where physical delivery of the two currencies does not take place. Under such arrangements, the underlying forward is liquidated relative to the spot rate at expiry. Non-deliverable forwards are covered later in this paper. Looking back at our previous example, we can see that we received more dollars by selling our 100 million JPY on the forward market than they were worth at spot. How can this be true even though the initial present value of a forward contract is zero? Before we visit the classical finance theory that explains this, let’s try to gain a more conceptual understanding. 1 AN INTUITIVE APPROACH ~ Let us begin by establishing that mechanically, a forward contract is simply a spot exchange rate transaction that incorporates the interest rate structure of each country. The parties agree to deliver one currency amount at the future date and in return agree to receive a corresponding amount of another currency, also on the future date. Through the structure, each party is effectively extending credit to the other party, expecting future payment. The concept of the time value of money works itself into this picture due to the credit aspect of the transaction. If you commit to deliver funds at a future date (sell currency forward) you are responsible for paying the interest on the currency, and if you commit to receive funds (buy currency forward) then you will receive the interest on that currency. The differential that exists is reflected in the difference between the spot and forward rate. It is left to the reader to conceptualize why as in our example, selling JPY forward versus USD derives a differential gain while buying JPY forward would result in a relative loss. (Hint: Rates are higher in US than in Japan.) COVERED INTEREST RATE ARBITRAGE ~ The forward rate is the rate at which the counterparties will execute the future currency exchange. This rate is based solely on the interest rate differential between the currencies and is derived so as to eliminate any possible arbitrage opportunities between the spot and interest rate markets. It is important to conceptualize that the forward FX, spot FX, and credit market prices are mutually consistent. The prevailing forward rate will guarantee that the initial net present value of the forward contract is zero; thereby ensuring the inter-market consistency. This relationship is known as covered interest rate arbitrage (Exhibit Two below). Exhibit Two: Covered Interest Arbitrage Transactions in Japan Transactions in US 100 million JPY USD/JPY Spot $775,194 @ 129.00 Invest in Japan @ 0.6953% Invest in USD @ 5.9375% for 1 Year for 1 Year Receive 100,695,300 USD/JPY 1Y FWD Receive $821,221 @ 122.62 We can see that the forward rate links the future value of two currencies just as the spot rate reflects their present value. At a USD/JPY spot rate of 129.00 and the respective risk-free rates of USD and DEM at 5.9375% and 0.6953%, the forward rate is set at 122.62. In an efficient market, this relationship holds. There is no arbitrage opportunity. COVERED INTEREST RATE ARBITRAGE: A PRACTICAL EXAMPLE ~ Suppose a US company expects to receive 100 million JPY in one years’ time. They can hedge the incoming flow and thereby lock in the USD value of their exposure by entering a 1- year forward contract. 2 We can evaluate the merits of such a decision by considering alternative transactions that would be required in order to synthesize this forward contract. The company would have to 1) borrow 100 million JPY for one year at the local risk-free rate, 2) convert the yen to USD at the current spot rate, 3) invest the proceeds at the US risk-free rate for one year, and 4) convert the Dollar proceeds to JPY and repay the loan. Covered interest rate arbitrage says that the total return of this process is identical to that of executing the outright forward, as Table One illustrates: Table One: Transaction Summary Transaction Interest Paid / Received 1. Borrow 100 million JPY for 1 year at <JPY695,300 0.6953% …hedge interest payment at /USD5,693> the forward rate 2. Convert 100 million JPY to USD at spot - rate 3. Invest $775,194 for 1 year at 5.9375% $46,027 4. Repay the Japanese loan <JPY695,300 /USD5,693> NET position: $40,334 Then net gain above is in fact identical to the cost of hedging earned by selling JPY forward for one year (100,000,000 / 129.00) - (100,000,000 / 122.62). This example helps us appreciate the non-arbitrage characteristic of the forward market. In fact, one could further argue that because borrowing at the risk-free rate is not really possible, forward hedging will generally be a lower cost hedging alternative to foreign borrowing. PRICING ~ The following formula is used to calculate the outright forward rate given the spot exchange rate and the corresponding risk-free interest rates. Formula 1: Outright Forward Rate F= Forward Rate S = Spot Rate 1+ Iv FS= ()T If = Interest Rate of Fixed Currency 1+ If Iv = Interest Rate of Variable Currency T = Time to Contract Expiry The forward points can be calculated using the following formula. Formula 2: Forward Points D S = Spot Rate as Market Quoted ()IISv- f «« Pts = 365 If = Interest Rate of Fixed Currency D Iv = Interest Rate of Variable Currency ()If « + 1 365 D = Days to Maturity Forwards deal at either premiums or discounts. Premium forward points must be added to the spot rate, making the forward rate higher than the spot rate. Discount forward points must be subtracted, of course making the forward rate lower. If you want to buy the fixed currency versus the variable currency forward, then premium points work against you, meaning that if you want 3 to sell the fixed currency forward, premium points work in your favor. The conditions are reversed for discount points. The difference here represents the interest rate differential that intrinsically is paid or received. This differential is also known as the cost of carry. As an example, let’s suppose a company is interested in buying USD forward versus ITL, with USD/ITL spot rate @ 1620.00 and the 6-month forward points quoted @ 1175. In this case we want to buy the fixed currency and sell the variable currency. The premium forward points make the forward rate less attractive. As another example, let’s suppose a company is interested in selling GBP forward versus DEM. The cross rate is quoted as GBP/DEM therefore the fixed currency is GBP and the variable currency is DEM. Discount forward points again work against us, as we are selling the fixed currency forward. A PRICING EXAMPLE ~ Now suppose another US company needs to make a payment to a German supplier in 6 months. To eliminate uncertainty, the firm locks in a rate today. We will subscribe to the preceding formula to illustrate how the forward points are derived. The company needs to buy a DEM forward, so the forward differential in this case works against us. The current spot rate is 1.7830 / 40, the 6 month Euro-DEM bid rate is 3.83594%, the Euro-USD offer rate is 5.90625%, and the contract will mature in 180 days. (Please note that the interest rates are quoted NOT as percentages but in decimal form). Formula Three: Forward Points 180 (..).00383594- 00590625 ««17830 Pts =360 = - 179 180 (.)00590625«360 + 1 The 6-month forward points are then quoted at -185 / -175. In 6 months, we will be purchasing JPY, so we are on the bid side of the market. If we take the spot rate and the respective 6-month forward points, we can arrive at the outright forward rate. The calculation is as follows. Formula Four: Outright Calculation Bid / Ask Spot Rate 1.78 30 / 40 6M FWD Pts. -185 / -175 1 . 7 8 3 0 - 0 . 0 1 8 5 1 . 7 6 4 5 Special attention must be paid in order to properly add or subtract forward points.
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