FX Forwards and their application- magazine Economy and Business


Vladimir Trajkovikj

Businesses that in their regular operation have import-export relations with foreign companies are exposed to currency risk permanently – risk against change of exchange rate, before all, due to extreme volatility of FX market.

Scope of the FX market is at the historically highest level and is incomparable with the scope of the remaining market instruments (stocks, corporate bonds shares etc.). High scope of trading is also resulting in high volatility of the FX market under terms of market uncertainty.

Change of prices at the foreign market may have significant influence over the cash flows of companies whose businesses are import-export dependable. Under circumstances when the businesses have liabilities or receivables in foreign currency to become due in near time or planned investments for which assets are to be allocated in near future, it is of extreme importance for the companies to mitigate the currency risk and protect against losses on the account of exchange rate differences. FX Forward, i.e. spot FX transaction is used as an extremely flexible instrument for dealing with the currency risk.

As an example, let us assume that a company exporter is expecting an inflow in amount of 1 USD million for a planned export in the next 3 months. Given that the company should convert this inflow into MKD, it is exposed to currency risk.

If the company is operating prudently, it shall arrange spot FX transaction with a commercial bank that shall fix the USD exchange rate for the period when the company expects the inflow. The exchange rate at the moment of signing the transaction amounts 56, 90 Denars for 1 USD. This practically means that the company, after converting the matured inflow, shall receive 56, 9 million Denars.

If the company does not sign the spot FX transaction, it shall be exposed to currency risk. Namely, if within three months period, the USD at the FX market weakens and at the day of receiving the inflow it is traded at 55, 90, this shall mean that the company shall convert the inflow at the market exchange rate and shall receive 55, 9 million USD.

It is obvious that the company by signing the spot transaction mitigates the currency risk and realizes additional 1 million USD.

Spot FX transaction is a committing contract for purchase or sale of one currency for another following exactly agreed exchange rate and agreed date in future. The basic risk for the bank which results from such type of a contract is the currency risk, although there is a component of interest risk, too.

In the spot FX transaction contract, one counter party (the client) is committing to purchase (or sell), and the other counter party (the bank) to sell (or purchase) the agreed amount and currency at an agreed date in future. At the moment of signing the spot transaction there is no settlement, i.e. there is no physical exchange of assets. Cash assets are exchanged at the due date of the spot transaction.

With the spot FX transaction, the future FX (or forward) exchange rate for exchange of the agreed amounts in the agreed currencies at some future date is fixed on the day of trading (signing) of the transaction. The remaining terms of the spot transaction (amount, currency to be purchased, currency to be sold and date of currency) are also to be agreed on the trading day.

Forward rate or the price at which the sale purchase is to be made at some future date is defined based on spot price (exchange rate) at the trading date which is corrected with appropriate number of forward points.

 Forward points represent a difference between the interest rates for both of the currencies to be exchanged. Forward points may be positive or negative depending on which of the currencies has higher or lower interest rate. As a rule, currency yield with higher market yield shall be discounted for the future period in calculating the forward points and vice versa.

Principal advantage of spot FX transactions relates to mitigating the currency risk – beneficiary of the forward knows the exact price of the currency which it purchases/sells and accordingly may plan the future cash flows. In addition, spot FX transactions are extremely flexible and may be tailored to the specific needs of the clients.

Failures of the spot FX transactions result, before all, from the extreme volatility of FX market which, at a given moment, may move in favor of the client who might not be able to profit due to the already signed, committing contract with the bank. In addition, by signing of the spot contract, the bank is exposed to credit risk given that there is a possibility for the client not to perform the agreed transaction in future. For that reason, the Bank may require margin which could represent additional costs for the client.

Spot FX transactions, just as any other instrument at the FX market, have their advantages and disadvantages as listed above. Certainly, if the client includes all the aspects in its operation on one hand, and the Bank dimensions the forward in agreement with the client’s needs on the other, the profit that the client shall have from the spot FX transaction is multiple one.

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