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Currency Forward or FX Forward Difinition and Pricing Guide Michael Taylor FinPricing

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Currency Forward A currency forward or FX forward contract is an agreement that allows the buyer to lock in an exchange rate the day on which the agreement is signed for a transaction that will be completed later. Forward contracts are one of the main methods used to hedge against exchange rate volatility as they avoid the impact of currency fluctuation over the period covered by the contract. The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations. By using FX forward contracts investors can protect costs on products and services purchased abroad and protect profit margins on products and services sold abroad by locking- in exchange rates as much as years in advance

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Currency Forward Summary  Currency Forward or FX Forward Introduction  The Use of Currency Forwards  Forex Market Convention  Forward FX Rate  Valuation  A Real World Example

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Currency Forward Currency Forward or FX Forward Introduction  A currency forward or FX forward is an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.  Currency forwards are over-the-counter OTC instruments. Unlike standardized FX future a FX forward can be tailored to a particular amount and delivery period.  Currency forward settlement can either be on a cash or a delivery basis provided that the option is mutually acceptable and has been specified beforehand in the contract.  Forward contracts are one of the main methods used to hedge against exchange rate volatility as they avoid the impact of currency fluctuation over the period covered by the contract.

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Currency Forward The Use of Currency Forwards  Currency forwards are an effective hedging vehicle and also allow buyers to indicate the exact amount to be exchanged and the date on which to settle in the forward contract.  If an investor will receive a cashflow denominated in a foreign currency on some future date that investor can lock in the current exchange rate by entering into an offsetting currency forward position that expires on the date of the cashflow.  Currency forwards can also be used to speculate and by incurring a risk attempt to profit from rising or falling exchange rates.  By using FX forward contracts investors can protect costs on products and services purchased abroad or protect profit margins on products and services sold abroad lock-in exchange rates as much as years in advance

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Currency Forward The Use of Currency Forwards Cont  Currency forwards are over-the-counter OTC instruments.  The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations.  A currency forward contract has credit risk. In the case that one of the parties is unable to fulfill its obligation the other party will have to sign another contract with a third party thus being exposed to market risk at that time.  By locking-in the exchange rates at which the currency will be bought the party forfeits the opportunity of profiting from a favorable exchange rate movement.

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Currency Forward Forex Market Convention  One of the biggest sources of confusion for those new to the FX market is the market convention. We need to make clear the meaning of the following terms in the forex market first.  FX quotation: the quotation EUR/USD 1.25 means that one Euro is exchanged for 1.25 USD. Here EUR nominator is the base or primary currency and USD denominator is the quote currency. One can convert any amount of base currency to quote currency by QuoteCurrencyAmount FxRate BaseCurrencyAmount

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Currency Forward Forex Market Convention Cont  Spot Days: The spot date or value date is the day the two parties actually exchange the two currencies. In other words a currency pair requires a specification of the number of days between the quotation date trade date and the Spot Date on which the exchange is to take place at that quote. Spot days can be different for each currency pair although typically it is two business days.  Holidays: Each currency pair has a set of holidays associated with it. The holidays of a currency pair is the union of the holidays of the two currencies.

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Currency Forward Forward FX Rate  Given spot rate spot date and forward date T the FX forward rate can be represented as ≥ where the spot FX rate quoted as base/quote t the valuation date the spot date several days after the valuation date T the forward date the discount factor of base currency the discount factor of quote currency

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Currency Forward Valuation  The present value of an FX forward contract is given by 0 − where t the valuation date T the payment date the spot FX rate quoted as base/quote the discount factor of base currency the discount factor of quote currency the notional principal amount for base currency the notional principal amount for quote currency

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Currency Forward A Real World Example Delivery Type Delivery Leg One Currency USD Leg One Notional 120750 Leg Two Currency CNY Leg Two Notional 826050.75 Net Price 6.841 Buy Sell Buy Base Currency USD Underlying Currency CNY Quotation USD/CNY Trade Date 10/25/2016 Maturity Date 2/26/2018

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