Lecture 6: The Forward Exchange
Market
Understanding Forward
Exchange Quotes and the
Use of the Forward Market
Where is this Financial Center?
Foreign Exchange Rate Quotes
and the Use of the Market

Recall that exchange rates can be quoted for
two possible settlement dates:



Immediate settlement (actually 1 or 2 business
days): Called the Spot Rate.
Settlement at some date in the future: Called the
Forward Rate.
Use of the forward market: To protect foreign
currency cash flows against foreign currency
exposure (specifically against unanticipated
changes in exchange rates).
Examples of Spot and Forward Quotes

Monday, October 4, 2010

GBP/USD
 Spot:
 1 month Forward
 3 month Forward
 6 month Forward
Rate
Pip Difference (From Spot)
1.5833
1.5829
- 4
1.5822
- 11
1.5812
- 21

USD/JPY
 Spot
 1 month Forward
 3 month Forward
 6 month Forward
83.42
83.39
83.33
83.22

- 3
- 9
-20
Source: Wall Street Journal:
http://online.wsj.com/mdc/public/page/2_3021-forex.html
Forward Discounts and Premiums
GBP/USD (i.e., American Terms):
GBP Selling at a Forward
Discount Against the USD
USD/GBP (i.e., European Terms):
USD Selling at a Forward
Premium Against the GBP
$1.5835
$1.5833
$1.5830
0.6326
0.6324
$1.5829
$1.5825
0.6324
0.6322
$1.5822
$1.5820
0.632
$1.5815
0.632
0.6318
$1.5812
$1.5810
0.6316
$1.5805
0.6314
$1.5800
0.6312
Spot
1-mos
3-mos
6-mos
forward forward forward
0.6318
0.6316
Spot
1-mos
forward
3-mos
forward
6-mos
forward
Forward Discounts and Premiums
USD/JPY (i.e., European Terms):
USD Selling at a Forward Discount
Against the JPY
83.45
83.4
JPY/USD (i.e., American Terms):
JPY Selling at a Forward
Premium Against the USD
$0.012020
83.42
$0.012010
83.39
83.35
$0.012017
$0.012015
$0.012005
$0.012001
$0.012000
83.33
83.3
$0.011995
83.25
$0.011990
83.2
83.22
$0.011992
$0.011988
$0.011985
$0.011980
83.15
$0.011975
83.1
$0.011970
Spot
1-mos
forward
3-mos
forward
6-mos
forward
Spot
1-mos 3-mos 6-mos
forward forward forward
Forward Premium or Discount?
Currency
Exchange Rate: Foreign Currency
Sept 27, 2011
Forward Discount
or Premium in Pips
USD/CHF
Spot
0.8959
1-month
0.8955
3-month
0.8941
6-month
0.8921
AUD/USD
Spot
0.9911
1-month
0.9871
3-month
0.9803
6-month
0.9713
USD: Forward
Discount or Premium
in Pips
Forward Premium or Discount?
Currency
Exchange Rate: Foreign Currency
Sept 27, 2011
Forward Discount
or Premium in Pips
USD: Forward
Discount or Premium
in Pips
USD/CHF
Spot
0.8959
1-month
0.8955
Premium (+4 pips)
Discount (-4 pips)
3-month
0.8941
Premium (+18 pips)
Discount (-18 pips)
6-month
0.8921
Premium (+38 pips)
Discount (-38 pips)
AUD/USD
Spot
0.9911
1-month
0.9871
Discount (-40 pips)
Premium (+40 pips)
3-month
0.9803
Discount (-108 pips)
Premium (+108 pips)
6-month
0.9713
Discount (-198 pips)
Premium (+198 pips)
Forward Exchange Contracts


Forward exchange contracts are over the counter
instruments written by market maker banks
Market maker banks quote bid and ask prices for
various currencies for forward periods upon request.



Bids are prices at which they will buy “base” currency and ask are
prices at which they will sell the “base” currency.
Popular journals publish forward quotes for standard time
periods. For example the Wall Street Journal publishes 1, 3
and 6 months forward.
However, forward contracts are not limited to these
standard periods. Quotes can be obtained for specific time
periods as requested by bank customers (thus tailored to
client needs).

Large banks will quote forward rates up to one year in the
majority of currency pairs and further out in the major currencies
(out to 5 and 10 years).
Outright Forwards

An outright forward exchange contract is a
transaction to buy or sell one currency against
another for a fixed forward value date.



The fixed forward value date is the contract’s
settlement date (note: this is similar to the spot value
date on a spot contract).
The forward exchange rate is fixed on the date
of dealing (called the forward trade date) and is
set against the current spot rate (i.e., on the spot
trade date).
An outright forward contract is a contractual
obligation on both parties, i.e., the bank and the
client.
Forward Quote Example

4/4/2011



Complete Quote (bid/ask)
Spot (GBP/USD):
6 month Forward (GBP/USD):
1.5833/1.5836
1.5812/1.5816
Thus the market maker will:

Buy GBP spot at $1.5833 and sell GBP spot at $1.5836;
spot trade date 4/4/2011 and spot value date
(settlement date) 4/6/2011.

Or: Buy GBP in 6 months at $1.5812 and sell GBP
in 6 months at $1.5816.

Note: The fixed forward value date (settlement) is 6
months from the spot value date (4/6/2011), or October 6,
2011 (see next slide for calendar).
2011 Calendar
Using the Forward Market to Hedge
(Cover) an Open Short Position

Assume: A U.S. firm has a British pound liability due in
6 months. The liability totals 1million GBP


Problem with an “uncovered” (open) short position.



Firm has an open short position in GBP.
If the GBP spot rate strengthens in 6 months, it will cost more in
USD to pay the liability.
Solution: U.S. company can “lock” in the USD cost of
the GBP liability by buying GBP 6 months forward at
the forward rate quoted.
In doing so, the U.S. firm has “covered” (i.e., hedged)
its GBP liability due in 6 months.
Example: Using the Forward Market to
Hedge (Cover) an Open Short Position


Use the information on the previous slide (a U.S. firm has
a 1million GBP 6 month open short position) and assume
the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known USD liability in 6 months if
the U.S. firm uses a forward contact to hedge its foreign
exchange exposure?
____________________________
Example: Using the Forward Market to
Hedge (Cover) an Open Short Position


Use the information on the previous slide (a U.S. firm has
a 1million GBP 6 month open short position) and assume
the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known USD liability in 6 months if
the U.S. firm uses a forward contact to hedge its foreign
exchange exposure?
₤1,000,000 x 1.5610 = $1,561,000
Using the Forward Market to Hedge
(Cover) an Open Long Position

Assume: A U.S. firm has a British pound account
receivable due in 3 months. The receivable totals 1
million GBP


Problem with an “uncovered” (open) long position.



Firm has an open long position in GBP.
If the GBP spot rate weakens in 3 months, the U.S. firm will
receive fewer U.S. dollars.
Solution: U.S. company can “lock” in the USD return of
the GBP account receivable by selling GBP 3 months
forward at the forward rate quoted.
In doing so, the U.S. firm has “covered” (i.e., hedged)
its GBP receivable due in 3 months.
Example: Using the Forward Market to
Hedge (Cover) an Open Long Position


Use the information on the previous slide (a U.S. firm has
a 1million GBP 3 month open long position) and assume
the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known USD equivalent expected in
3 months if the U.S. firm uses a forward contact to hedge
its foreign exchange exposure?
_______________________
Example: Using the Forward Market to
Hedge (Cover) an Open Long Position


Use the information on the previous slide (a U.S. firm has
a 1million GBP 3 month open long position) and assume
the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known USD equivalent expected in
3 months if the U.S. firm uses a forward contact to hedge
its foreign exchange exposure?
₤1,000,000 x 1.5620 = $1,562,000
Using the Forward Market to Hedge
(Cover) an Open Short Position


Assume: A British firm has a 1 million USD liability due
in 1 month. Assume the following market maker quotes
for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known GBP liability in 1 month if
the British firm uses a forward contact to hedge its
foreign exchange exposure?
_______________________
Using the Forward Market to Hedge
(Cover) an Open Short Position


Assume: A British firm has a 1 million USD liability due
in 1 month. Assume the following market maker quotes
for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known GBP liability in 1 month if
the British firm uses a forward contact to hedge its
foreign exchange exposure?
1/1.5629 = 0.6398362 x $1,000,000 = ₤639,836.20
Using the Forward Market to Hedge
(Cover) an Open Long Position


Assume: A British firm has a 1 million USD account
receivable which it expects to receive in 3 months.
Assume the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known GBP equivalent expected in
3 months if the British firm uses a forward contact to
hedge its foreign exchange exposure?
________________________
Using the Forward Market to Hedge
(Cover) an Open Long Position


Assume: A British firm has a 1 million USD account
receivable which it expects to receive in 3 months.
Assume the following market maker quotes for GBP/USD:
 Spot
1.5634/1.5637
 1 month 1.5629/1.5632
 3 month 1.5620/1.5624
 6 month 1.5608/1.5610
Question: What is the known GBP equivalent expected in
3 months if the British firm uses a forward contact to
hedge its foreign exchange exposure?
1/1.5624 = 0.6400409 x $1,000,000 = ₤640,040.90
Forward Exchange Contract Risks


Credit Risk (counterparty risk): The risk that the
currency contracted to be purchased or sold on
some future date will not be delivered.
(1) Bank Risk (“Herstatt Risk”*): Risk that the
bank which sold the client a forward contract will
default prior to payment.


*Named after German bank I.D. Herstatt which
unexpectedly closed in 1974 and thus defaulted on its
FX commitments (both spot and forwards).
(2) Client Risk: Risk that client who purchased a
forward contract fails to deliver currency.


Client might go bankrupt, or
Foreign currency account receivable is not paid (to
client).
Protecting Against Counterparty
Risk

Bank Risk: Deal with only the top (and most
credit worthy) banks.


Stay away from banks with overexposures in high
risk areas.
Client Risk:


Ensure payment on foreign currency account
receivables through bankers’ acceptances.
Bankers’ acceptances: Payment is guaranteed by
commercial bank (not dependent upon the foreign
company).
Forward Quotes

Day’s close (in actual rates)


http://online.wsj.com/mdc/public/page/2_3021forex.html
Rates (in pips from spot)

http://www.forexpros.com/rates-bonds/forwardrates

We will examine this site in more detail in the next
lecture (The Forward Market and the Forward Exchange
Rate)
Bankers’ Acceptances





A bankers acceptance is a time draft drawn on a bank, and is
typically used to finance an international transaction where an
exporter is unwilling to offer their goods or services on credit to
an importer.
A banker's acceptance is issued by the importer and is an order
for its bank to pay an exporter certain amount of money at a
predetermined date. Once the bank accepts this order, they are
liable for payment to the exporter.
Once the Bankers acceptance has been signed by the bank on
behalf of the importer, the exporter may either hold the
acceptance until maturity date or sell it on the secondary market
at a discount of its par.
Bankers acceptances are a major part of the U.S. money
markets, providing liquidity to exporters and low risk interest
income to secondary market buyer . They are typically traded at
a spread above the U.S. T-bills and the rate is referred to as the
Banker's Acceptance rate.
For current bankers’ acceptances rates view:
http://online.wsj.com/mdc/public/page/2_3020-moneyrate.html
Life Cycle of a Bankers’ Acceptance
A Bankers’ Acceptance (Madura,
page 567)