Financial institutions screen potential buyers of FX forward contracts to protect themselves from counterparty default risk. Different institutions have different screening methods, but all methods try to measure the creditworthiness of the client. This involves analysis of the potential client’s current and historical financial position and credit history. It is worth noting that financial institutions often already have an ongoing relationship with the FX forward client. A potential client must also demonstrate sufficient understanding of the FX market. The financial institution also considers the stated purpose for buying an FX forward. Clients must have economic basis for buying the forward, such as to hedge a specific foreign exchange risk exposure. Speculation is usually discouraged. A minimum principal size might also be specified by contract writers and a maximum principal size by regulators.
Once a client has been successfully screened for purpose, expertise and creditworthiness, an over-the-counter forward is structured to the specific needs of the client. The most basic components of maturity, principal and currency pair are specified first. In order to structure an effective hedge, these components must be matched to the FX risk exposure that the client faces. The principal is determined by considering the amount of exposure. FX risk exposure can be an exact amount (such as when a client has a fixed expense in the future) or an estimated amount (such as when future cash flows are uncertain). It is also important to match the timing of expected obligations. There are four relevant dates that must be specified, these are:
1. Contract date – the date that the terms of a contract are accepted by either party 2. Fixing date – the date that the forward rates are calculated for the FX forward 3. Maturity date – the date that the contract matures
4. Settlement date – the date that the parties settle the contract by either trading the full principal or difference in forward rate and spot rate at maturity
For most FX forward contracts, the contract and fixing dates are the same, but they may be separated in special cases. Also, in most cases, the maturity and settlement dates are the same. They may be separated in order to give the client payment flexibility, in these cases a range of acceptable settlement dates can be set by the financial institution. They are also often separated for non-deliverable forwards, which will be discussed in the next section.
The forward rate is also specified in the contract. The forward rate might be determined from the outset (usual case) or could be fixed at a later date (the previously above mentioned fixing date), in this case, the contract must specify how the forward rate will be determined on fixing date. Forward rates are often quoted in forward points (which are also called swap points). Forward points are measured in pips and are the difference of forward price and spot price. If the forward price is above the spot price, the commodity currency is said to trade at a forward premium and if forward price is below spot price, a forward discount. Financial institutions earn a profit by having different bid forward and offer forward rates.
Deliverable versus Non-Deliverable
One important specification of a forward contract is whether the principal is deliverable or not. In a deliverable forward, upon settlement, the full principal is traded at the forward rate. For a non-deliverable forward (NDF), the principal is entirely notional. Rather than settling by trading the full principal, the forward rate is compared to the spot rate at maturity (more specifically, the spot rate two days before maturity date assuming spot transactions are settled t+2). The difference is multiplied to the notional principal to calculate the settlement. Effectively, in an NDF, only the loss or gain that would have occurred under a deliverable forward is paid by one party to another. NDF’s can have other features as well. Some NDF contracts allow for early termination at an extra cost or for possible extension past maturity at an extra cost. The choice between deliverable and non-deliverable forwards depends on the risk being hedged. If the risk exposure is for a specific amount, deliverable forwards are appropriate and if the exposure is uncertain, an NDF can be used.
FX swaps are a special usage of FX forwards. They are discussed here because they play a prominent role in the global FX markets, accounting for 47% of total FX turnover in 2010 according to the Bank for International Settlements; this is a portion larger than both outright forwards and outright spot transactions. An FX swap is essentially an extension of an outstanding forward position. Entities with an outstanding FX forward contract can enter an FX swap in order to effectively extend the maturity and settlement dates of their contract. An FX swap is a combination of an offsetting spot transaction and new forward contract. When the outstanding forward comes close to maturity, an opposite spot transaction is executed in order to balance out the commodity currency. Thus, the entity is able to settle the outstanding forward by paying or receiving only the terms currency.
The entity also enters into a brand new forward contract that has similar specifications as the previous one but with later maturity; thus, the entity is able to roll it’s position forward. The effect of FX swaps is analogous to FX futures. In an FX future, there is a daily settlement/marking to market even though final maturity is at a later date. FX swaps can also be considered as a kind of marking to market that simultaneously pushes final maturity to a later date. FX swaps are popular because they give companies flexibility in their positions. FX swaps can be used to string together short-maturity forwards to create a hedge for a longer position. This allows for a kind of early termination of a forward position (by using shorter maturities than usual) or extension (by rolling forward again and again). Furthermore, in the case of favorable FX movements, FX swaps provide companies with extra liquidity.
CFA: Level I Study Sessions. London: Pegasus Learning, 2011. Print. Hull, John. Options, Futures & Other Derivatives. Upper Saddle River, NJ: Prentice Hall, 2003. Print. “Non-deliverable Forward Transactions.” WestPac.com.
Westpac Banking Corporation, 9 Oct. 2009. Web. 27 July 2012. . “Triennial Central Bank Survey.” Www.bis.org. Bank of International Settlements, Dec. 2010. Web. 26 July 2012. .