Printer FriendlyIf the contract is
cancelled or the expected payment will not be forthcoming for any reason, the
exporter must instruct his bank to close out the Forward FX contract. This can
be done at any time between the date of learning that payment will not be
received and the settlement date of the Forward FX contract.
The date chosen to
close out can depend on the exporter's view of the of the Spot Rate movement up
to the original settlement date. However, for simplicity of explanation, we can
chose to close out on the maturity date of the original forward FX contract.
To close out the FX
contract the bank would sell to the exporter the missing $US10, 000 at the
current Spot Rate. This is used to settle the original Forward FX contract and
avoids the exporter being in default.
The bank then pays
the exporter the outturn of the original FX deal. The difference between the cost of
$US10, 000 at the current Spot Rate and the outturn from the original
Forward FX contract is debited or credited to the exporter's account as the
case may be.
The same process
applies for importers buying currency to pay a supplier, except that the
contract would be for the bank to sell the currency.
FX Contract Rollover/Extension
Buy and Re-sell
An exporter faced
with delays in payment has the option to roll over i.e. extend the Forward FX
contract and so avoid the need to close out. The process is similar to closing
out an FX contract, but with a major difference.
The exporter buys the overdue currency at the Spot Rate to fulfil the original Forward FX contract but sells it forward again simultaneously to the new expected date for the delayed receivables.
This procedure is
effective but cumbersome. It also involves paying two Spreads - one between the
buying and selling Spot Rate for the original deal, and one for the rollover
deal.
There is an
alternative and cheaper method for closing out a Forward FX Contract making use
of a Swap procedure.
Swaps
'A swap is an
agreement to purchase/sell one currency for a second, for one value date
(usually Spot) and sell/purchase the first currency for the second for a
different value date.
With short-dated
foreign exchange swaps (typically available for the same period as the
equivalent forward market), the exchange rates used for the two value dates
reflect the spot (or forward) rate at the start of the swap period and the
forward rate at the end of the swap period.
For longer-dated
swaps, usually transactions made under ISDA (International Swaps and
Derivatives Association) documentation, the exchange rate used for the two
value dates is usually the same and the parties will make a series of
compensatory semi-annual or annual payments reflecting the interest
differential inherent in the swap.'
Swapping Maturity Dates
Where the payment date and cashflow is uncertain, it may be easier to hedge the FX cashflow through the Forward FX market by asking the bank to swap the maturity dates, i.e. adjust the settlement dates of the hedge by means of a short 'Swap' contract.
All that is involved is that the original Spot Rate is adjusted by the difference in the original forward premium (or discount) and the new forward premium (or discount).
For example, if payment is to be made earlier than originally expected, the foreign currency required by the buyer to make the payment may be bought on the Spot market then sold Forward for the same value date as the original forward purchase.
On the other hand, if the payment is to be made later, the foreign currency proceeds of the original Forward FX contract should be sold Spot and bought Forward for the revised payment date.
The benefits of
using Swap Forward FX contracts as opposed to the alternative of Spot purchase
and deposit are:
(a) avoids the
significant 'spread' cost on deposits. The cost of the rollover is reduced as
only one 'composite' Spread is involved.
(b) avoids inflating
the gross borrowing on the balance sheet
Swap rates are
stated in terms of points of discount or premium from the Spot Rate. For
example if 3-month forward US Dollar was $US1.65/£ and the Spot Rate was
$US1.60/£ then the forward discount on the US Dollar would be $US0.0500, known
on the FX market as 500 points.
Interest Rates - Premiums/Discounts
Interest rates are a reflection of the state of a country's economy and level of inflation. They are linked to the strengths and weaknesses of an individual currency in the long term.
This means that
strong currencies with low interest rates will be sold at a higher forward
exchange rate or premium. A currency with a high interest rate will be sold at
a discount or lower forward exchange rate.
For example, assume
that the interest rate of the US Dollar is 10% pa while that of the Japanese
Yen is 5% pa.
If selling US
Dollars and buying Japanese Yen, the one-year forward US Dollar/Yen exchange
rate would have a 5% premium on the Yen Spot Rate. That is to say that it would cost 5% more in US
Dollar terms to protect the buyer of Yen from the risk of adverse currency
fluctuation.
It can be considered
as the premium cost of insuring the risk.
The following are
some examples of how the Forward FX market can be used to hedge risk and to
assist in commercial decisions.
(The exchange rates
and interest rates used are not necessarily based on the current market levels)
EXAMPLE
A company enters
into a three month forward contract to exchange for receipts of $US5million at
$US1.4145/£.
The Spot Rate at the
time the payment is received is $US1.4251/£.
The buyer pays the
$US5million on time, and the :
$US5, 000,000 = £3,534,817.96
1.4145
The outturn that the
exporter would have received on date of payment at the Spot Rate of $US1.4251
would have been £3,508,525.72.
So not only did the
exporter eliminate currency risk, but also made a gain of £26,292.24
Example - Option Forward Contract - Sell
Where actual day of payment is uncertain
An
exporter wants to sell 100,000 Euros to his bank for Pounds Sterling. The Euros
are expected to be available sometime between month one and end of month
three:-
Spot Rate 1.59 – 1.64
1 Month Forward 1.67 – 1.72
3 Months Forward 1.75 – 1.81
Bank
will quote the most favourable rate to itself for the period of the option.
It
will take the lowest selling rate and the highest buying rate.
Therefore: Option
Forward rate (1 to 3 months) = 1.67 – 1.81
The Euros are sold to the bank which converts them at the buying rate of 1.81 to the pound.
The
exporter thus receives from bank Euros100, 000/1.81 = £55,248.62 (less bank
charges).
Example - Option Forward Contract - Buy
Where actual day of payment is uncertain
An importer enters an FX contract to purchase Euros100, 000 at any time during the next three months. The bank will compare the Spot Rate (EUR1.6435/£1.00) with that for three months forward and quote as follows:
Spot 3months
Spot Rate
1.6435 1.6435
Deduct Forward Premium - 0.0010
1.6435 1.6425
As the bank is
selling Euros, the lower rate will be the more favourable to itself.
Therefore it will
quote: EUR1.6425/£1.00 and charge the
importer £60,882.80
Example - FX Contract Close Out
Exporter - Selling currency
On 1st April an
exporter enters into a forward FX contract to sell $5,000 for settlement on 1st
July at a rate of $1.5770/£1.
On 1st July the
exporter is unable to provide the currency and instructs his bank to close out
the FX contract.
a) The $US Spot Rate has strengthened to $1.5750/£1
The close out
calculation is:
Bank sells exporter $5,000 at 1.5750 = |
£3,174.60 |
Exporter honours original FX contract $5000 at 1.5770 = |
£3,170.58 |
£4.02 |
Bank will debit the
exporter's account with the difference of £4.02.
b) The $US Spot Rate has weakened to Spot Rate
$1.5850/£1
The close out calculation is
Bank sells exporter $5,000 at 1.5850 = |
£3,154.57 |
Exporter honours original FX contract $5000 at 1.5770 = |
£3,170.58 |
£16.01 |
Bank will credit the exporter's account with the difference of £16.01.
EXAMPLE - FX Contract Close Out
Importer - Buying currency
An importer enters
into a forward FX contract to purchase $3,000 on 1st June at a forward rate of
$1.50/£1.
On 1st June the
importer decides that the dollars are no longer required and instructs his bank
to close out the FX contract.
a) The $US Spot Rate has strengthened to $1.45/£1
The close out calculation is:
Importer honours original FX contract and buys $3000 at 1.50 = |
£2,000.00 |
Importer sells back $3000 to Bank at 1.45 = |
£2,068.97 |
£68.97 |
Bank will credit the
importer's account with the difference of £68.97
b) The $US Spot Rate has weakened to Spot Rate $1.55/£1
The close out calculation is:
Importer honours original FX contract and buys $3000 at 1.50 = |
£2,000.00 |
Importer sells back $3000 to Bank at 1.55 = |
£1,935.48 |
|
£64.52 |
Bank will debit the
importer's account with the difference of £64.52
These examples do not include
FX transaction costs that are usually payable to the bank. Sometimes banks include them in the rate of exchange they quote
Where there are a
number of relatively small FX payments to be made, a currency overdraft can be
used where it is possible to establish such accounts.
A local currency overdraft facility with a bank in the buyer's country enables the buyer to pay local currency into the seller's local overdrawn account. This can also save some bank charges by reducing the number of cross border transfers.
Where the duration
of the exposure is relatively long (e.g. more than 2-months) it is useful to
use Forward FX contracts in conjunction with currency overdrafts for the
following reasons:
- financing FX receivables for long periods by currency overdraft is likely
to be more expensive than the use of Forward FX contracts; and
- financing FX receivables for long periods by currency overdraft exposes the seller to variations in overdraft interest rates in the foreign currency and risk of devaluation in the buyer's country.
Forward FX contracts and Currency options are explained in detail below.
If you are importing or exporting, for expert commercial foreign exchange services, speak to us at Raphael's Bank.
Quick and easy foreign exchange deals via our branch network, treasury centres or over the Internet.
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