Forward exchange cover

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to [1] buy or sell an asset at a specified future time at a price agreed upon today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized [2] assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded over the counter (OTC), forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or [ additional collateral to better secure the party at gain.

Payoffs
The value of a forward position at maturity depends on the relationship between the delivery price ( and the underlying price ( ) at that time. )

For a long position this payoff is: For a short position, it is:

[edit]How

a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current ratethese two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts. [edit]Example

of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the

money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him the opportunity cost will be covered. [edit]Spotforward

parity

Main article: Forward price See also: Cost of carry and convenience yield For liquid assets ("tradeables"), spotforward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset: pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities); or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.) [edit]Investment

assets
) and spot ( )

For an asset that provides no income, the relationship between the current forward ( prices is

where is the continuously compounded risk free rate of return, and T is the time to maturity. The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery. Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. For an asset that pays known income, the relationship becomes: Discrete: Continuous:

where the present value of the discrete income at time , and is the continuously compounded dividend yield over the life of the contract. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. Hence the income ( or ) must be subtracted to reflect this benefit. An example of an asset which pays discrete income might be a stock, and example of an asset which pays a continuous yield might be a foreign currency or a stock index. For investment assets which are commodities, such as gold and silver, storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:

Discrete: Continuous:

where the present value of the discrete storage cost at time , and is the continuously compounded storage cost where it is proportional to the price of the commodity, and is hence a 'negative yield'. The intuition here is that because storage costs make the final price higher, we have to add them to the spot price. [edit]Consumption

assets

Consumption assets are typically raw material commodities which are used as a source of energy or in a production process, for example crude oil or iron ore. Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include the ability to profit from temporary shortages and the [1] ability to keep a production process running, and are referred to as the convenience yield. Thus, for consumption assets, the spot-forward relationship is:

Discrete storage costs: Continuous storage costs:

where is the convenience yield over the life of the contract. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward, it can be modelled as a type of 'dividend yield'. However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity. If users have low inventories of the commodity, this implies a greater chance of shortage, which means a [1] higher convenience yield. The opposite is true when high inventories exist. [edit]Cost

of carry

The relationship between the spot and forward price of an asset reflects the net cost of holding (or carrying) that asset relative to holding the forward. Thus, all of the costs and benefits above can be summarised as the cost of carry, . Hence,

Discrete: Continuous:

[edit]Relationship

between the forward price and the expected future

spot price
Main articles: Normal backwardation and Contango

The market's opinion about what the spot price of an asset will be in the future is the expected future [1] spot price. Hence, a key question is whether or not the current forward price actually predicts the respective spot price in the future. There are a number of different hypotheses which try to explain the relationship between the current forward price, and the expected future spot price, .

The economists John Maynard Keynes and John Hicks argued that in general, the natural hedgers of [3][4] a commodity are those who wish to sell the commodity at a future point in time. Thus, hedgers will collectively hold a net short position in the forward market. The other side of these contracts are held by speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will hence only enter the contracts if they expect to make money. Thus, if speculators are holding a net long position, it must be the case that the expected future spot price is greater than the forward price. In other words, the expected payoff to the speculator at maturity is: , where Thus, if the speculators expect to profit, is the delivery price at maturity

, as

when they enter the contract

This market situation, where , is referred to as normal backwardation. Since forward/futures prices converge with the spot price at maturity (see basis), normal backwardation implies that futures prices for a certain maturity are increasing over time. The opposite situation, where , is referred to as contango. Likewise, contango implies that futures prices for a certain [5] maturity are falling over time. [edit]Rational If

pricing
, and is the continuously compounded .

is the spot price of an asset at time

rate, then the forward price at a future time

must satisfy

To prove this, suppose not. Then we have two possible cases. Case 1: Suppose that following trades at time . Then an investor can execute the : at the continuously ;

1. go to the bank and get a loan with amount compounded rate r;

2. with this money from the bank, buy one unit of stock for

3. enter into one short forward contract costing 0. A short forward contract means that the investor owes the counterparty the stock at time . The initial cost of the trades at the initial time sum to zero. At time the investor can reverse the trades that were executed at time Specifically, and mirroring the trades 1., 2. and 3. the investor 1. ' repays the loan to the bank. The inflow to the investor is 2. ' settles the short forward contract by selling the stock for inflow to the investor is now the investor. because the buyer receives .

; . The cash from

The sum of the inflows in 1.' and 2.' equals , which by hypothesis, is positive. This is an arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is called a cash and carry arbitrage because you "carry" the stock until maturity. Case 2: Suppose that . Then an investor can do the reverse of what he has done above in case 1. But if you look at the convenience yield page, you will see that if there are finite stocks/inventory, the reverse cash and carry arbitrage is not always possible. It would depend on the elasticity of demand for forward contracts and such like. [edit]Extensions

to the forward pricing formula

Suppose that expiration time

is the time value of cash flows X at the contract . The forward price is then given by the formula:

The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset. If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices. As a result, the forward price for nonperishable commodities, securities or currency is no more a predictor of future price than the spot price is - the relationship between forward and spot prices is driven by interest rates. For perishable commodities, arbitrage does not have this The above forward pricing formula can also be written as:

Where

is the time t value of all cash flows over the life of the contract.

For more details about pricing, see forward price. [edit]Theories

of why a forward contract exists

Allaz and Vila (1993) suggest that there is also a strategic reason (in an imperfect competitive environment) for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to firms having Stackelberg incentives to anticipate their production through forward contracts.

What is a forward exchange contract?

Setting a foreign exchange rate for the future could make a huge difference to your profitability. Learn how foreign currency can work for you and how you might benefit from securing a forward exchange contract. If youre the kind of exporter who watches exchange rate movements with a little trepidation, maybe its time to consider ways of managing your money beyond the daily rate. Fluctuations in the foreign currency market occur for various reasons, but are mostly in tune with traders appetite for risk. But the perception of risk changes dailyeven hour-by-hour as political announcements occur, company information comes to light and global events unfold. To avoid the whims of traders, exporters dealing in foreign currency for business transactions are advised to lock in a forward exchange contract. Put simply, a forward exchange contract is an agreement between you and your provider to exchange a specified amount of one currency for another currency on a particular date, using a set rate calculated at the point of making the contract. The aspect that you need to remove from your thinking is that the forward rate is a prediction of the exchange rate at that future dateit is not. A forward exchange contract is made up of two components: the spot component, which is effectively the rate of the two currencies on the day, and the forward component, which is a reflection of the interest rate differential, the difference between the interest rate in one country versus another over that time period, explains Tim Keith, head of Treasury Management at the National Australia Bank. At the end of the day there is no other mathematically correct way to do it. Anyone with foreign currency transaction in their business should consider setting up a forward exchange arrangement with their financial institution; most providers will offer this once they understand the foreign exchange requirements of your business.

Any business that has exposure to a currency through importing, exporting or trade of some sort should consider the use of forward exchange contracts. It doesnt matter if youre big, small or in between, says Keith. He suggests that a forward exchange contract should centre on existing supply contracts you have with customers. In some markets thats just from month-to-month, he says. Meat is a classic example where there are no long-term supply contracts, they tend to have much smaller tenure forward exchange contracts or they just use the spot market, whereas there are other businesses that have contracts to supply 12 months or two years out. That will obviously increase the tenure of their contract. Forward exchange contracts can be negotiated for up to 10 years into the future, though this length of tenure is understandably rare. Its really uncommon because no one has [supply] contracts out for 10 years. What theyre saying is that they dont consider that their business model will change dramatically in a 10-year period and therefore theyre willing to lock in their cash flow, Keith explains. Your relationship with your exchange provider will help you decide whats appropriate for your business, so be open about what you want to achieve and what you want out of the contract. They might say I want to lock in a rate for 12 months and then after we talk to them and understand their business, we find out theyre actually going to be paid the currency in six months well say Why are you going for 12 months out? says Keith. Thats simplistic case but thats the process followed.

Forward exchange benefits and drawbacks

The main benefit of a forward exchange contract is knowing how much m oney youre going to get for a sale upon payment. Relying on the spot market makes this difficult. For example, you might do a deal where you sell goods with a price tag of US$100,000 to a customer, with a payment term of 90 days. If, at the time of making the sale, the rate was

US60c to A$1, then you would have received approximately A$166,667 had the customer paid on that day. However, 90 days down the track, if the rate became US80c to A$1, you would only receive A$125,000. If you had instead entered into a forward exchange contract, it would have taken into account the spot rate and the interest rate of both countries over the quarter. The difference between the present and future amounts would have been a lot less. This is extremely important for maintaining profit margins, says Keith: Its about how much their business can afford in terms of exchange rate changes. So if the exchange rate moves 30 percent, does it make the business unprofitable and put them out of business, or do they have such large margins that they can accommodate that? Certainty also has positive follow on effects including predicting cash flow and other types of business planning, so you may need to consider how having a forward exchange contract may affect other parts of your business. A disadvantage of a forward contract is that you cannot take advantage of the rate if it moves in your favour. If you took out a forward exchange contract and a scenario occurred with the rate US80c to A$1 at first, then US60c to A$1 when payment fell due, you could have missed out on about A$40,000.

Managing risk
A halfway point is to use forward exchange contracts, but only for some of the amount you need exchanged. That way, your business is only partially exposed to currency fluctuations, and you can take advantage of any movements in your favour. To do this you will need to understand how much exposure your business can handle and then combine the best of both the spot and forward rates in a ratio with which youre comfortable. And everyone is different, Keith adds: Every business and every manager has their own individual risk profile so some people are happy to accept a little bit more risk and other people are completely risk averse.

He says the current global recession has thrown up a few interesting scenarios, especially around the uncertainty of the business environment. This means you need to take care with anything scheduled for the future. People take forward exchange contracts against future sales or future purchases and when those sales or purchases dont happen because their buyer goes out of business or cant pay because of the economic situation, the contract between the bank and the customer still needs to be honoured, he points out. That can have a detrimental effect on a business cash flow. Its important to consider those possible outcomes. But in general, interest rates around the world have all fallen and that means forward exchange rates havent been as crazy as the spot market, where Keith observes there have been huge fluctuations in currency based on the state of their economy. The arpeggio of the spot market has seen this form of currency management retain its popularity. People are still looking for forward exchange contracts to get some certainty because with the large movements they cant afford the adverse ones, says Keith. Obviously they kick themselves around the positive ones, but they couldnt have it the other way, so people are still using them.