Forex Investment and Currency Trading

Forwards Market – Introduction

• Buy EUR sell USD value today
• Buy EUR sell USD value 6 months

• Usually much longer

Applications of Forwards

Forward Pricing

• Are forward points linear?
• Each yield curve has its own uniquely shaped curve, reflecting different interest rate expectations
• Because forward curves can be steep, flat, inverted, positive-to-negative, negative-to-positive, etc., the “forward points per day” can change dramatically
• Therefore, interpolating forward points is not always correct
• Bid Offer is wider for longer tenors, less liquidity

Forwards Market – Making Prices for Clients

• Points divided by 10,000 = decimal format
• -9/10,000 = -0.0009
• With a spot reference of 1.2710, the all in forward rate is 1.2701

• Points divided by 100 = decimal format
• -102/100 = -1.02
• With a spot reference of 94.45, the all in forward rate is 93.43

Forex Forwards Market

• USD-CAD is currently trading at 1.2252
  • If USD-CAD falls to 1.1675, that means the 50 million CAD purchase will cost about 2.00 MM USD more than today
  • If USD-CAD rises to 1.2875, that means the 50 million CAD purchase will cost about 2.00 MM USD less than today
• The FX Forward market allows you to lock in a fixed USD cost TODAY for delivery in the FUTURE
• Forward price = Spot price + Forward (or swap) points

Forwards

Buy CAD 50 million – unhedged at maturity

• The current spot = 1.2252, so cost is USD 40.8 million
• But if the spot rate at maturity is 1.50, then the company would pay only USD 33.3 million
• If the spot at maturity is 1.00, then the answer is USD 50 million

CAD 50 million sold forward 3 months

• Net result: the uncertainty over the outcome has been eliminated
• The corporation loses out now if the Canadian dollar depreciates …
• … but gains if it appreciates

FX Forward Hedge Example

• US Corp needs to buy CAD 50 million for delivery in 3 months time. How do they lock in the USD cost today?
• -Execute a forward contract to buy CAD 50 million 3 months forward
  • Forward price = Spot price + Forward (or swap) points
  • Buy CAD forward at 1.22615 (Spot = 1.2252 + 95 forward points)
  • Lock-in USD cost of $40,778,045.10

• Buy CAD sell USD spot to lock in the USD cost
• Borrow USD to deliver on contract … won’t have underlying USD for 3 months
• Invest the CAD proceeds for 3 months until you pay the invoice
• In 3 months, delivery CAD to vendor repay USD borrowing
• Three financial products involved: spot FX, CAD interest rates & USD interest rates

FX Forward Hedge – Deconstructed

• US Corp needs to buy CAD 50 million for delivery in 3 months time. How do they lock in the USD cost today?
  • Buy CAD 50 million for spot value at 1.2252 ($40,809,663.73)
  • Borrow $40,809,663.73 for three months at 1.05%
  • Deliver the USD to settle spot contract
  • Invest the CAD 50,000,000 for three months at 1.36%
  • In three months, pay CAD invoice to vendor
  • Repay USD borrowing
  • Net USD Cost is fixed at $40,778,036.24
    • CAD interest earned is CAD 170,000 or USD 138,752.86
    • USD interet expense $107,125.37
    • Net income from borrowing / investment = $31,627.49
    • $40,809,663.73 - $31,627.49 = 40,778,036.24
  • Effective FX rate of CAD Purchase = 1.22615 (50,000,000 / 40,778,036.24)

  The Reality

• Instead of Corporate borrowing and investing on their own … they would just ask for a forward price
• The bank would quote the customer 1.22615 to buy CAD 3 months forward 1.2252 + 9.5 forward points
  • Spreads in the forward market are tighter than the spreads a corporation would get if they tried to manufacture the forward business by themselves in the spot and interest rate markets
• How do FX traders determine forward points?
  • Traders monitor interest rate curves on a real time basis (futures markets, Depo markets, inter-bank forward markets)
  • If the traders can synthetically borrow and lend different currencies, FX forwards can be quoted, dealt and covered

  FX Forward Traders – How forward prices are constructed

  • Hedge risk with Exchange Traded Interest Rate Futures
  • Interest rate futures contracts imply a certain rate of interest for a deposit starting at some point in the future
  • Interest Rate Future Contracts
    • Eurodollar (U.S. Dollars)
    • Euribor (Euros)
    • Euroswiss (Swiss Francs)
    • Euroyen (Japanese Yen)
    • Short Sterling (British Pounds)
    • Bankers’ Acceptance (Canadian Dollars)

    Forward Discount or Premium

    If currency is quoted in USD Base

    • If foreign interest rates are higher than U.S. rates, then forward points are Positive (add the points)
    • If foreign interest rates are lower than U.S. rate, then forward points are Negative (subtract the points)

    If currency is quoted in Foreign Currency Base

  • If foreign interest rates are higher than U.S. rates, then forward points are Negative (subtract the points)
  • If foreign interest rates are lower than U.S. rate, then forward points are Positive (add the points)
  • If U.S. interest rates increased and all other rates remain unchanged
    • Forward points on the Japanese yen and Canadian dollar (USD Base) would become more negative
    • Forward points on the Euro (Euro Base) would become more positive
    • Forward points on the Brazilian real and the Mexican peso would become less positive