AFMP4
Syllabus E. Treasury And Advanced Risk Management Techniques E2. The use of financial derivatives to hedge against forex risk

E2b. Forward Rates 4 / 13

Syllabus E2b)

b) Evaluate, for a given hedging requirement, which of the following is the most appropriate strategy, given the nature of the underlying position and the risk exposure:

i) The use of the forward exchange market and the creation of a money market hedge

Forward Rates

So, remember what we are looking at here are ways to negate the risk that, in the future, the exchange rates may move against us

So we have bought or agreed a sale now in a foreign currency, but the cash won’t be paid (or received) until a future date

With a forward rate we are simply agreeing a future rate now.

Therefore fixing yourself in against any possible future losses caused by movements in the real exchange rate

However - you also lose out if the actual exchange rate moves in your favour as you have fixed yourself in at a forward rate already

Illustration

UK importer has to pay $1,000 in a months time
He takes the forward rate of $1.8-1.9:£
The bank then has agreed to SELL the dollars (counter currency) to the importer. 

Remember the bank SELLS LOW

The exchange rate would therefore be $1.8:£

So, the bank will give the exporter $1,000 in return for £555. 

The importer must pay £555

  • NOTE 

    If importer cannot fulfill the forward contract agreed (maybe because he didnt receive the goods) the bank will sell the importer the currency and then buy it back again at the current spot rate.

    This closes out the forward contract

Advantages of forward rate

  1. Flexible

  2. Straightforward

Disadvantages of forward rate

  1. Contracted commitment (even if you haven’t received money)

  2. Cannot benefit from favourable movements