By Amrit Basu
Foreign Exchange Forward Rates are the market's intelligent and arithmetically determined 'guess' of where a currency pair will be in relation to each other at a given point of time in future. The worth (or the risks attached to) of a currency is assumed, and a reward (in terms of higher interest rates) is given to those who hold the riskier currencies. It is a useful tool for everybody who has a foreign exchange exposure.

In simple terms, Foreign Exchange Forward is a transaction whereby a customer can exchange a currency which he has for a currency he does not have at an agreed rate on a date in the future. This is the simplest form of a Derivative transaction. In order to assess the importance of the Forwards, let us see the statistics nearer home. Following are the data of the Spot and Forward deals done in one week both in the Interbank market as well as in the Merchant transactions, as per Reserve Bank of India, vide its latest weekly press release.

Let us start from a point where the market is in equilibrium, where it assumes that in one year from now, the rate of Euro against the US Dollar will be 1.5000.This assumption will mainly be based on the current interest rates and other fundamental factors. But, let us also assume that players are now willing to pay 1.6000 for Euro, because they feel that holding the Euro even at this rate will be beneficial to them, because of its higher rate of interest.

Therefore, it (the higher rate of interest) is a way of compensating them for the risk of Euro going down to 1.5000 in a year's time. It is imperative to note that the interest rate influences the Spot rate quite significantly, even as the market expectation of the forward rate may remain same. As an extension of the above example, an interest rate hike in Euro may take the Spot rate to 1.7000, and a fall may pull it down to 1.5500.But the Forward one-year rate will remain at 1.5000.

While, the currencies which are fully convertible, like Euro, Sterling Pounds etc attract forward premium/discount absolutely on the basis of interest rate differentials ( barring a few exceptions), currencies like Indian Rupee are influenced also by supply and demand, it being a currency not fully convertible.Forward rates are a composite product of the Spot rates and the interest rate differential of the two currencies. The transactions are able to take place because of the presence of natural depositor-investors and natural borrowers in various currencies.

The Basics
Let's get down to the calculations. Forward foreign exchange deals are dealt as fx swaps, where the market user buys one currency against the other for a certain value date, and sells the same currency against the other for a different value date. For example, I may show my interest to Buy Euro 1 million against US Dollars for value Spot, and Sell Euro 1 million against US Dollar for value forward, say, 1 month from the Spot date.

Here, 'value dates' are the dates on which the delivery of the currencies will take place. And, in this example, Euro is the Base Currency and US Dollar is the Quoted Currency. The Market User always buys and sells in Base Currency. Let us assume that we have an investor who has Euro 10 million to be invested for a period of one year. His Banker is willing to pay him 5% per annum. However, he intends to explore the possibilities of depositing in other currencies.

The Bank tells the investor that it is willing to sell him US Dollars (against the Euros, he has) at 1.5000 (the current Spot rate), and but will pay him 3%, if he intends to keep the deposit in US Dollars. If he agrees, he will get US Dollars 15 million (being EUR 10 million converted at 1.5000 US Dollars to 1 Euro).

So the investor has two options:

In Euro: EUR 10 million @ 5% for 1 year (365) days give him a total of EUR 10.5 million i.e. ((EUR 10m*5%*365 days)/365) +EUR 10 m= EUR 10.5 m

In US Dollar: USD 15 m will give him USD 15.45 million since, ((USD 15m*3%*365)/365)+USD 15 m = USD 15.45 million
From this example, we can safely say that one year hence, other things remaining constant, EUR 10.5 million will be equivalent to US Dollars 15.45 millions. This means that the rate of exchange, the market perceives to be there on exact expiry of a period of 1 year, will be 1 EUR= 1.4714 US Dollars i.e. (USD 15.45/EUR 10.5)

Again from this we can infer that US Dollars 0.0286 (1.5000 present exchange rate 1.4714 forward exchange rate), is the premium the market is willing to pay to the person who is holding Euros. In foreign exchange parlance, this difference of 0.0286 is the exact implication of the interest rate differentials between Euros and US Dollars, and is called 'pips' or 'forward points (in this case it is 286 pips).

The pips are normally in four decimal points (like 0.0286); but in case of currencies where the Spot rate is denominated by a higher number (say, Japanese Yen), the forward points are in two decimal points (say 0.52). It is worthwhile to note that where the high-yielding currency is the base currency, the forward points get deducted from the spot rate to arrive at the forward rate. Similarly, the forward points would get added to the spot rate if the base currency is a low-yielding currency.

Value Dates
Value Dates are days on which a currency or a pair of currency is delivered to its contractual owner. All currency quotes, unless otherwise mentioned, are quoted for the Spot date, which is two working days from the trade date. Any date beyond the Spot date is the Forward date. In international markets, the forward rates are quoted for exact 1,2,3,6 and 12 months ( that is, delivery of the currencies will be done say, 1 month after the Spot date, 2 months after the Spot date etc).
However, there are certain conventions. If we are trading on say, 27th of Feb ( in a leap year), for which the Spot date is 29th of February; the 1 month forward will not be 29th of March, but 31st of March. Similarly, if we are trading on 29th of January, the spot date being Jan 31st, the 1 month forward will not be 2nd of March, but 29th of February. The Indian market is a little different.

Here, forward rates are quoted for the end of the calendar month that is last business day of the month, 31st Dec, 31st Jan, 29 Feb etc. If the forward rate is asked/quoted for a non-regular date, it is called 'broken dates' or 'odd dates'. Value dates earlier than 1 month forward are called Short Dates. Other terminologies like Spot-Next (one day after the Spot date), Spot-week (One week forward) are also used by the market.

The Indian Connection
In the Indian context, forwards assume more significance as it is also used by the Central Bank as a tool to temper the strength/weakness of the local currency. If the Central Bank has intervened in the market by buying US Dollars against the Indian Rupee (value Spot) to arrest the appreciation of the latter, it may so happen that on the Spot date, the Rupees released by the Central Bank to the market may have other monetary implications.

Therfore, it sterilizes the effect by selling the US dollars (value Spot), and taking back the Rupees, simultaneously buying the Dollars value a Forward Date. It serves quite a few purposes: a) it stops the local currency from strengthening, b) it does not give additional liquidity to the market on the spot date, and c) it raises the forward premium (as more forwards dealt will affect the premium market as a function of more demand and less supply, as suggested earlier), thereby assuaging the feelings of the exporters who would have otherwise been affected by the Rupee appreciation.

All in all, Foreign Exchange Forwards are a relatively safe tool to hedge one's exposure. It is less complicated, easily understood, and more liquid. It gives the satisfaction that one has been able to crystallize one's liabilities at a rate which is determined now for a future date. However, over a period of time continued research in financial engineering has thrown up various other products. We will discuss the implications of the Foreign Exchange Forwards on the more complicated forms of such products, known as Derivatives in the coming issues.

Amrit K. Basu is the Head Treasury Products of proFX consulting & allied services, a Treasury Risk Management consultancy outfit. Amrit is also engaged in offering advisory to software companies as well as in placements in the treasury domain. He can be reached at amritbasu@profxconsulting.in.

This story appeared in COMMODITY MARKET, India’s No 1 news magazine on commodities