What Is the Underlying in a Foreign Currency Forward Contract

Under the terms of the contract, the counterparty must compensate the exporter by making a payment to the exporter equal to the difference between the fixed rate and the current exchange rate. In this case, the exporter will receive $0.2 million from the consideration as cash compensation. If the spot price for USD/EUR = 0.7395, it means that 1 USD = 0.7395 EUR. The interest rate in Europe is currently 3.75% and the current interest rate in the US is 5.25%. In 1 year, 1 dollar earning US interest will be worth 1.0525 US dollar and earn 0.7395 euros, which brings the European interest rate of 3.75%, will be worth 0.7672 euros. Thus, the 1-year spot forward rate is equal to 0.7672/1.0525 or, using the equation above (note, however, that rounding errors between the 2 different methods used to calculate the forward rate result in slight differences): How does a currency term work as a hedging mechanism? Suppose a Canadian exporter sells goods worth $1 million to a U.S. company and expects to receive export products in a year. The exporter is concerned that the Canadian dollar has risen from its current rate (1.0500) in one year, meaning it would receive fewer Canadian dollars per U.S. dollar. The Canadian exporter therefore enters into a futures contract to sell $1 million per year in the future at a forward rate of $1 = C$1.0655. The value of a term position at maturity depends on the ratio between the delivery price ( K {displaystyle K} ) and the underlying price ( S T {displaystyle S_{T}} ) at that time.

Some currencies cannot be exchanged directly, often because the government restricts these exchanges, such as the Chinese yuan renminbi (CNY). However, a trader can get a futures contract on the currency, which does not lead to the delivery of the currency, but is instead settled in cash. If, in the meantime and at the time of the actual transaction date, the market exchange rate is $1.33 to 1 euro, the buyer has benefited from the blocking of the rate of 1.3. On the other hand, if the exchange rate in effect at that time is 1.22 US dollars to 1 euro, the seller benefits from the currency futures business. However, both parties have benefited from the purchase price freeze, so the seller knows his costs in his own currency and the buyer knows exactly how much he will receive in his currency. If S t {displaystyle S_{t}} is the spot price of an asset at time t {displaystyle t} and r {displaystyle r} is the continuously compound price, then the forward price at a future time must meet T {displaystyle T} F t , T = S t e r ( T − t ) {displaystyle F_{t, T}=S_{t}e^{r(T-t)}}. The payment date is the day you receive your currency. Currency futures are standardized futures. Futures are contracts traded individually and traded over-the-counter, while futures are standardized contracts traded on organized exchanges. Most futures trades are used to hedge currency risk and end with the actual delivery of the currency, while most futures positions are closed before the delivery date, as most futures contracts are bought and sold only for potential profit.

(See the future table of contents for a good introduction to futures.) A currency futures transaction is an adjusted written contract between two parties that sets a fixed exchange rate for a transaction that will take place on a specific future date. The future date for which the exchange rate is set is usually the date on which both parties plan to carry out a transaction of buying/selling goods. In finance, a futures contract, or simply a futures contract, is an atypical contract between two parties to buy or sell an asset at a specific future time at a price agreed at the time of conclusion of the contract, making it a type of derivative instrument. [1] [2] The party that agrees to buy the underlying asset in the future takes a long position, and the party that agrees to sell the asset in the future takes a short position. The agreed price is called the delivery price, which corresponds to the forward price at the time of conclusion of the contract. A futures contract is an agreement, usually with a bank, to exchange a certain number of currencies for a specific rate – the forward exchange rate – at some point in the future. Futures are considered a form of derivatives because their value depends on the value of the underlying asset, which, in the case of currency futures, are the underlying currencies. The main reasons for futures are speculation on profits and hedges to limit risk. While hedging reduces currency risk, it also eliminates the opportunity cost of potential profits. Forward foreign exchange contracts are typically used by exporters and importers to hedge their foreign currency payments against exchange rate fluctuations.

Currency futures can also be concluded between an individual and a financial institution for purposes such as paying for future vacations abroad or financing education in a foreign country. Had there been no futures contract, the exporter would have received $11.8 million by exchanging €10 million at the market exchange rate. Since the currency will grow faster in the country with the higher interest rate and the parity of interest rates must be maintained, it follows that the currency with a higher interest rate will trade at a discount on the currency futures market and vice versa. So, if the currency has a discount on the futures market, subtract future points quoted in pips; Otherwise, the currency will trade at a premium in the futures market, so add it up. Dividing the two parts by the future value of the base currency results in the following: relative to their futures counterparts, futures contracts (especially forward rate agreements) require convexity adjustments, i.e. a drift term that takes into account future changes in interest rates. With futures, this risk remains constant, while the risk of a futures contract changes as prices change. [11] “Given the uncertainty caused by Covid-19 and now Brexit, UK exporters are increasingly concerned about currency volatility. Futures can help you get a favorable exchange rate with key foreign partners and gain security and security at minimal upfront cost. Suppose, for example, that Company A in the United States wants to enter into a contract for a future purchase of machine parts from Company B based in France.

Therefore, changes in the exchange rate between the US dollar and the euro can affect the actual price of the purchase – up or down. The parity of interest rates determines the amount of the forward price. So how can you benefit if interest rate parity is not respected? The forward rate is determined on the basis of the spot price – the market exchange rate at the time of conclusion of the contract – and the “interest rate difference” over the term of the contract. The interest rate difference is the interest rate difference between two currencies. Suppose that F V T ( X ) {displaystyle FV_{T}(X)} is the fair value of cash flows X at the time of expiration of contract T {displaystyle T}. The forward price is then indicated by the formula: if the spot rate in a year is US$1 = C$1.0300 – which means that the C$has appreciated as expected by the exporter – the exporter has benefited from the pegging of the forward rate of C$35,500 (by selling the US$1 million at C$1.0655, instead of the cash rate of C$1.0300). On the other hand, if the year-over-year spot rate is C$1.0800 (i.e., .B the Canadian dollar has weakened contrary to the exporter`s expectations), the exporter has a fictitious loss of C$14,500. The similar situation works with currency futures, where a party opens a futures contract to buy or sell a currency (para. B a contract to purchase Canadian dollars) that expires or is settled at a later date because it does not want to be exposed to foreign exchange or exchange rate risk over a period of time. Because the exchange rate between the U.S. dollar and the Canadian dollar fluctuates between the trading date and the previous closing or expiry date of the contract, one party wins and the counterparty loses when one currency becomes stronger against the other.

Sometimes the buy forward is opened because the investor actually needs Canadian dollars at a later date, .B. to pay debt denominated in Canadian dollars. In other cases, the party opening a date does so not because it needs Canadian dollars or because it hedges the currency risk, but because it speculates on the currency and expects the exchange rate to move favorably to make a profit when the contract is concluded. If a transaction that may be affected by exchange rate fluctuations is to take place at a later date, setting the exchange rate allows both parties to budget and plan their other business activities without fear that the future transaction will place them in a different financial situation than expected. Currency futures are only used in a situation where exchange rates can affect the price of goods sold. .