Main Instruments - Outright Forwards

OUTRIGHT FORWARDS

An outright forward transaction, like a spot transaction, is a straightforward single purchase/ sale of one currency for another. The only difference is that spot is settled, or delivered, on a value date no later than two business days after the deal date, while outright forward is settled on any pre-agreed date three or more business days after the deal date. Dealers use the term “outright forward” to make clear that it is a single purchase or sale on a future date, and not part of an “FX swap” (described later).

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There is a specific exchange rate for each forward maturity of a currency, almost always different from the spot rate. The exchange rate at which the outright forward transaction is executed is fixed at the outset. No money necessarily changes hands until the transaction actually takes place, although dealers may require some customers to provide collateral in advance.

Outright forwards can be used for a variety of purposes—covering a known future expenditure, hedging, speculating, or any number of commercial, financial, or investment purposes. The instrument is very flexible, and forward transactions can be tailored and customized to meet the particular needs of a customer with respect to currency, amount,and maturity date.Of course, customized forward contracts for nonstandard dates or amounts are generally more costly and less liquid, and more difficult to reverse
or modify in the event of need than are standard forward contracts. Also, forward contracts for minor currencies and exotic currencies can be more difficult to arrange and more costly.

Outright forwards in major currencies are available over-the-counter from dealers for standard contract periods or “straight dates” (one, two, three, six, and twelve months); dealers tend to deal with each other on straight dates. However, customers can obtain“odd-date” or “broken-date” contracts for deals falling between standard dates, and traders will determine the rates through a process of interpolation. The agreed-upon maturity can range from a few days to months or even two or three years ahead, although very long-dated forwards are rare because they tend to have a large bid-asked spread and
are relatively expensive.

Relationship of Forward to Spot—Covered

Interest Rate Parity The forward rate for any two currencies is a function of their spot rate and the interest rate differential between them. For major currencies, the interest rate differential is determined in the Eurocurrency deposit market.Under the covered interest rate parity principle, and with the opportunity of arbitrage, the forward rate willtend toward an equilibrium point at which any difference in Eurocurrency interest rates between the two currencies would be exactly offset, or neutralized, by a premium or discount in the forward rate.

If, for example, six-month Euro-dollar deposits pay interest of 5 percent per annum, and six-month Euro-yen deposits pay interest of 3 percent per annum, and if there is no premium or discount on the forward yen against the forward dollar, there would be an opportunity for “round-tripping” and an arbitrage profit with no exchange risk. Thus, it would pay to borrow yen at 3 percent, sell the yen spot for dollars and simultaneously resell dollars forward for yen six months hence, meanwhile investing the dollars at the higher interest rate of 5 percent for the six-month period

This arbitrage opportunity would tend to drive up the forward exchange rate of the yen relative to the dollar (or force some other adjustment) until there were an equal return on the two investments after taking into account the cost of covering the forward exchange risk. Similarly, if short-term dollar investments and short-term yen investments both paid the same interest rate, and if there were a premium on the forward yen against the forward dollar, there would once again be an opportunity for an arbitrage profit with no exchange risk, which again would tend to reduce the premium on the forward yen (or force some other adjustment) until there were an equal return on the two investments after covering the cost of the forward exchange risk.

In this state of equilibrium, or condition of covered interest rate parity, an investor (or a borrower) who operates in the forward exchange market will realize the same domestic return (or pay the same domestic cost) whether investing (borrowing) in his domestic currency or in a foreign currency, net of the costs of forward exchange rate cover.

The forward exchange rate should offset, or neutralize, the interest rate differential between the two currencies. The forward rate in the market can deviate from this theoretical, or implied, equilibrium rate
derived from the interest rate differential to the extent that there are significant costs, restrictions,
or market inefficiencies that prevent arbitrage from taking place in a timely manner. Such constraints could take the form of transaction costs, information gaps, government regulations, taxes, unavailability of comparable investments (in terms of risk, maturity, amount, etc.), and other impediments or imperfections in the capital markets. However, today’s large and deregulated foreign exchange markets and Eurocurrency deposit markets for the dollar and other heavily traded currencies are generally free
of major impediments.

Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies

Forward contracts have existed in commodity markets for hundreds of years. In the foreign exchange markets, forward contracts have been traded since the nineteenth century, and the concept of interest arbitrage has been understood and described in economic literature for a long time. (Keynes wrote about it and practiced it in the 1920s.) But it was the development of the offshore Eurocurrency deposit markets—the markets for offshore deposits in dollars and other major currencies—in the 1950s and ‘60s that facilitated and refined the process of interest rate arbitrage in practice and brought it to its present
high degree of efficiency, closely linking the foreign exchange market and the money markets of the major nations, and equalizing returns through the two channels.

With large and liquid offshore deposit markets in operation, and with information transfers greatly improved and accelerated, it became much easier and quicker to detect any significant deviations from covered interest rate parity, and to take advantage of any such arbitrage opportunities. From the outset, deposits in these offshore markets were generally free of taxes, reserve requirements, and other government restrictions.

The offshore deposit markets in London and elsewhere quickly became very convenient for, and closely attached to, the foreign exchange market. These offshore Eurocurrency markets for the dollar and other major currencies were, from the outset, handled by the banks’ foreign exchange trading desks, and many of the same business practices were adopted. These deposits trade over the telephone like foreign exchange, with a bid/offer spread, and they have similar settlement dates and other trading conventions. Many of the same counterparties participate in both markets, and credit risks are similar.

It is thus no surprise that the interest rates in the offshore deposit market in London came to be used for interest parity and arbitrage calculations and operations. Dealers keep a very close eye on the interest rates in the London market when quoting forward rates for the major currencies in the foreign exchange market. For currencies not traded in the offshore Eurocurrency deposit markets in London and
elsewhere, deposits in domestic money markets may provide a channel for arbitraging the forward exchange rate and interest rate differentials.

w How Forward Rates are Quoted by Traders Although spot rates are quoted in absolute terms—say, x yen per dollar—forward rates, as a matter of convenience are quoted among dealers in differentials—that is, in premiums or discounts from the spot rate. The premium or discount is measured in “points,” which represent the interest rate differential between the two currencies for the period of the forward, converted into foreign exchange.

Specifically, points are the amount of foreign exchange (or basis points) that will neutralize the interest rate differential between two currencies for the applicable period. Thus, if interest rates are higher for currency A than currency B, the points will be the number of basis points to subtract from currency A’s spot exchange rate to yield a forward exchange rate that neutralizes or offsets the interest rate differential.

Most forward contracts are arranged so that, at the outset, the present value of the contract is zero.
Traders in the market thus know that for any currency pair, if the base currency earns ahigher interest rate than the terms currency, the base currency will trade at a forward discount,or below the spot rate; and if the base currency earns a lower interest rate than the terms currency, the base currency will trade at a forward premium, or above the spot rate.

Whichever side of the transaction the trader is on, the trader won’t gain (or lose) from both the interest rate differential and the forward premium/discount. A trader who loses on the interest rate will earn the forward premium, and vice versa. Traders have long used rules of thumb and shortcuts for calculating whether to add or subtract the points.Points are subtracted from the spot rate when the interest rate of the base currency is the higher one, since the base currency should trade at a forward discount; points are added when the interest rate of the base currency is the lower one, since the base currency should trade at a forward premium

Another rule of thumb is that the points must be added when the small number comes first in the quote of the differential, but subtracted when the larger number comes first.For example,the spot CHF might be quoted at“1.5020- 30,” and the 3-month forward at “40-60” (to be added) or “60-40” (to be subtracted). Also, the spread will always grow larger when shifting from the spot quote to the forward quote. Screens now show positive and negative signs in front of points,making the process easier still.

Non-Deliverable Forwards (NDFs)

In recent years,markets have developed for some currencies in “non-deliverable forwards.” This instrument is in concept similar to an outright forward, except that there is no physical delivery or transfer of the local currency. Rather, the agreement calls for settlement of the net amount in dollars or other major transaction currency. NDFs can thus be arranged offshore without the need for access to the local currency markets,and they broaden hedging opportunities against exchange rate risk in some currencies otherwise considered unhedgeable. Use of NDFs with respect to certain currencies in Asia and elsewhere is growing rapidly.