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How does a FX Forward transaction work?
| 27-11-2017 | treasuryXL |
FX Forward Contract
A Foreign Exchange Swap (also known as a FX Forward) is a two-legged transaction where one currency is sold or bought against another currency at a determined date, and then simultaneously bought or sold back against the other currency at a future date. Normally this means the first transaction would take place at the prevailing spot rate and settle on the spot date, whilst the forward transaction would prevail at an agreed forward rate and settle on the agreed forward date. The difference between the Spot price (or first price) and the Forward price (or second price) represents the FX Forward and is expressed as Swap points.
What are Swap points?
Swap points represent the cost of borrowing one currency, whilst simultaneously lending another currency for a time period equal to the swap period. Swap points are therefore the cost of carry netted out between two currencies and used to adjust the existing Spot price to express the Forward price.
Worked example
Currency 1 ABC
Currency 2 XYZ
Period 6 months
Days in period 183
Interest rate 6 months ABC 4%
Interest rate 6 months XYZ 7%
Spot ABC/XYZ 2.1025
For ABC 1,000,000.00 there are XYZ 2,102,500.00
ABC 1,000,000.00 * (1+4/100*183/360) = ABC 1,020,000.00
XYZ 2,102,500.00 * (1+7/100*183/360) = XYZ 2,177,313.96
XYZ 2,177,313.96/ABC 1,020,333.33 = 2.1339
Swap points = +/+ 314 pips
What does this mean?
The Forward price of 2.1339 is higher than the Spot price of 2.1025 and means that the currency ABC trades at a forward premium to currency XYZ. Therefore, the Swap points of 314 pips are added to the current Spot price. A bank that is quoting would only quote the Swap points. A two-way quote would look something like 304/324. At 304 the bank would sell and buy ABC – spot against 6 months – against buying and selling XYZ. At 324 they would do the complete reverse.
So is the Forward price the same as a future?
No, the Forward price is not an attempt to determine the future value of currency ABC expressed in the price of currency XYZ. It is a price that is derived by notionally hedging the notional values of both currencies against their respective interest rates that are applicable at that moment in time. The Forward price is an example of interest rate parity – a state of non-arbitrage or equilibrium where traders are indifferent to either as there is no monetary advantage in either. Forwards are traded ‘Over the Counter’ and not via an exchange. Regardless of what the future value of spot ABC/XYZ is, once the trade has been executed there can only ever be opportunity loss or profit in the bookkeeping.
Variations
FX Forwards can also be forward starting – a client might wish to create/hedge an exposure starting in 4 months’ time and with a tenor of 6 months. This would be seen as a 6 month starting in 4 months’ time – or a 4m*10m. Such a Forward would be calculated from the present spot to both 4 months and 10 months, with the present Spot rate adjusted for the Forward price for 4 months to reflect the new starting price.
Alternatively, instead of swapping a position, a client might just wish to hedge their exposure/obligation in the future by trading ‘Outright’. If they were to buy ABC forward they would enter into a FX Swap (sell ABC at spot and buy forward) and then immediately buy ABC at spot, offsetting the spot leg of the FX Swap.
What moves the price?
Changes in the underlying interest rates of both currencies will affect the calculation. Also as the interest rate differential of the two currencies is expressed as a price of the existing spot rate, changes in the spot rate will also cause changes in the outcome of the calculation – though generally smaller than those caused by changes in interest rates.
Why trade FX Forwards?
FX Forwards allow a company to hedge future exposure/obligations. Once the contract has been struck that value is confirmed and is not subject to ‘mark-to-market’ variation orders as happens with an off-balance-sheet instrument. An exposure in one currency can be transformed into another currency via use of a FX Forward. An expected inflow or outflow that is delayed can be rolled forward by using a FX Forward.
Lionel Pavey
Cash Management and Treasury Specialist
The treasurer plays with fire, when hedging foreign currencies to his sole gut feelings
| 24-11-2017 | Rob Beemster |
The foreign exchange market is a highly volatile market and therefore full of surprises. For more than 20 years, I was a spot currency trader in the dealing room of a large international bank. One of the things I liked the most in being a trader was the unpredictability of the markets. Never a dull moment. The management of the bank gave us a lot of freedom, once you had proven the ability to handle this. But always we had to take care of some very important requirements, like the VAR (Value At Risk), and we had to protect our positions with stop-loss orders.
Executing a stop-loss was the worst part of my job. It proved that you had been wrong in judging a certain move of a currency. It sometimes felt like being a loser. However, executing at a stop-loss level gives you the freedom to restart a new currency position. We were never blamed by colleagues or the management for having executed a stop-loss. It was part of the risks, and by using a stop everyone knew that overall business would never be hurt. If losses taken by stops were in line with the profits taken (relatively speaking) everything would be fine, considering that a good trader makes more positive decisions then negative ones.
Now let’s consider the controller who decides on his hedges, based on his gut feelings. Most probably this is based on old nonsensical ideas like, “what goes up must go down”, and, “It will come back to old levels”. Because of my business today, I speak with finance managers about their hedging strategies. Sometimes they make me feel embarrassed because of their self-created strategies; “I like to play foreign currency strategy myself”, or; “we have had good years and less good years”. From a business economic point of view this can be very painful. Volatility in foreign currencies is a very important component of international business. But one has to realize that this component can be managed. Companies should install a risk management procedure on their foreign currency exposure/obligations, to preserve their profit margins. A proper strategy not only protects the margins and cash flow but will also create prudency within the entire company.
A currency strategy is an implemented structure, necessary for the finance department. However, others that are responsible for the flows, like sales departments, procurement or production, should be involved and be aware of the importance of the strategy as well. Our models do describe the tasks of all the departments. A communication plan is part of the currency strategy. When the implemented processes are understood by everyone within the company, then and only then the strategy will work.
Our foreign currency risk models are very useful within international operating corporations. We can help you to implement the processes that will secure cash flows. A controller, who makes decisions on FX out of the blue, is unacceptable and too dangerous for the continuity of the business, moreover, it is intolerable in modern finance departments.
Barcelona valuta experts can be of assistance to you. After precise research of the current status of your company we can implement the right models. And this will protect you against negative or unwelcome currency moves.
Rob Beemster
Owner of Barcelona valuta experts BV
TIS (Treasury Intelligence Solutions) at the DACT Treasury Fair
| 22-11-2017 | treasuryXL | TIS Treasury Intelligence Solutions |
Company Profile
TIS is the leading cloud platform for managing corporate payments, liquidity and banking relationships worldwide. The company delivers SMART PAYMENTS to help customers make BETTER DECISIONS. TIS enable companies to make more efficient, more secure and more cost-effective payment transactions. In addition, TIS enables customers to make better decisions when analysing financial and operational performance based on real-time payment flows. All mission-critical processes related to payment transactions are integrated into a multibank-capable, audit-proof cloud platform. This is a single point of contact for enterprise customers when managing and analysing their payment flows across the organisation. TIS take care of managing various payment formats, communication channels with banks, and ERP-agnostic integration. Offered as Software as a Service (SaaS), the ISO certified TIS solutions are quickly up and running without the complexity and cost of a long IT project.
If you are at the Treasury Fair, please take your time to visit their stand and mention treasuryXL.
Last week TIS raised $12 million in additional financing from international VC firm 83North. Read more on their website
This is TIS’s own announcement on their website announcing their participation.
We wish TIS success at the DACT Treasury Fair!!
If you want to find out more about TIS and their services and products please refer to their company profile on treasuryXL.