Forward Exchange

What is a Forward Exchange ?

The forward exchange is used in hedging by exporters or importers in the case of the currency of each compensation is not the same. You can take the example of a French company (EUR), which exports to the United States (USD). The French company will receive dollars. When a transaction is made, the company does not receive payment instantly of what she billed to the customer. It will maybe conclude that such payment will be in 3 months. But during this period, the EUR / USD may change considerably. What fear the French company is that the EUR/USD appreciates. Indeed, he will receive the same number of USD but they have a lower value in Euro. She will therefore lose money. Any foreign exchange transaction which takes place in the future will generate a risk. This is called exchange risk. The forward exchange allows you to eliminate almost all the exchange risk by fixing upon the signing of the contract the price which will be applied at maturity.

Two methods of hedging

Continue with the example of our exporter. To eliminate the risk, the French company has 2 solutions:
– The spot hedging
– The forward hedging

Spot hedging is the fact to be cover immediately by borrowing the currency that you will receive if you are exporting. To borrow consist in a double operation. In this case, the exporter will sell USD and buy EUR. Thus, it has hedged its currency risk. Indeed, if the price of the EUR / USD goes up, it will gain on the spot transaction he did and will lose on the USD received in 3 months. The transaction is balanced.

The forward hedging is another method of coverage. It consists of the realization of a forward sell. In our case, the exporter will sell forward USD. He will for that, call his bank who will provide him a forward exchange rate. This price is equal to the difference between the spot exchange rate and the interest rate differential between two currencies (called premium or discount). The forward rate is lower or higher than the spot because it takes into account the interest rate differential (cf carry trade). Thus any arbitrage is impossible. The forward rate of the currency 1 relative to currency 2 will be the one that fail to make an economic agent prefer the currency 1 or 2. Now back to our example. If the exporter sells forward USD, the risk is the fall of the EUR/USD. But in 3 months, he will receive payment of the U.S company in USD. If the price of the EUR / USD has fallen, his dollars will have a higher value in euros. Thus, the two are balanced. This has ensured that the USD they will received will give the forecast of Euros in 3 months.

It is the treasurer of the company who decide what strategy used. The foreign exchange market is nearly efficient, income from the two operations must lead to the same result in theory. The treasurer must take into account the potential variation of the rate differential.

The calculation of the forward exchange rate

FER= S*((1+r2*n/360)/(1+r1*n/360))

S = Spot
R2 = Interest rate of the quoted currency
R1 = Interest rate of the base currency
N = Number of days of holding

This result shows that the forward rate is equal to the ratio of the forward rate of the 2 currencies considered (these values are measured by the interest rate) and linked by their parity.

The forward rate is in no way predictive of what will be the exchange rate in the future. It’s just a price equilibrium that avoids arbitration.

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