FORWARDS, NDFS AND SWAP

Ivan O. Asensio, Bank of America Global Corporate and Investment Bank

THE FORWARD CONTRACT ~

In plain language, a forward contract is a commitment today to conduct business sometime in the future. It is a very simple concept, but an important one since forwards are often the first products used by companies and remain a principal risk management product for many. Economically it provides the perfect hedge. Parties can lock in a price today and forget about it. They are guaranteed execution at that particular level, regardless of subsequent market fluctuations.

The parties who enter of a foreign exchange forward agree to exchange one currency for another on a future date, at a specified rate of exchange. It is very similar to a spot transaction, with the difference being that the commitment date occurs further in the future. The cash exchange in a spot transaction occurs typically in two days whereas a forward exchange takes place beyond the spot delivery date. Illustrated in Exhibit One (below) is an example comparing the sale of 100 million JPY spot vs. 100 million JPY forward. Exhibit One: Spot and Forward Transactions
Spot Transaction COMPANY Spot Transaction 1/1/XX 100 million JPY @ 129.00 1/1/XX 100 million JPY @ 122.62 FWD Transaction COMPANY 1Y Fwd Transaction

$775,194 USD

$815,528 USD

Delivery on 1/3/XX

Delivery on 12/31/XX

Unless otherwise noted, the forward agreement entails physical delivery of the specific currencies. Agreements can also be structured with net cash settlement, where physical delivery of the two currencies does not take place. Under such arrangements, the underlying forward is liquidated relative to the spot rate at expiry. Non-deliverable forwards are covered later in this paper. Looking back at our previous example, we can see that we received more dollars by selling our 100 million JPY on the forward market than they were worth at spot. How can this be true even though the initial present value of a forward contract is zero? Before we visit the classical finance theory that explains this, lets try to gain a more conceptual understanding.
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AN INTUITIVE APPROACH ~ Let us begin by establishing that mechanically, a forward contract is simply a spot exchange rate transaction that incorporates the interest rate structure of each country. The parties agree to deliver one currency amount at the future date and in return agree to receive a corresponding amount of another currency, also on the future date. Through the structure, each party is effectively extending credit to the other party, expecting future payment. The concept of the time value of money works itself into this picture due to the credit aspect of the transaction. If you commit to deliver funds at a future date (sell currency forward) you are responsible for paying the interest on the currency, and if you commit to receive funds (buy currency forward) then you will receive the interest on that currency. The differential that exists is reflected in the difference between the spot and forward rate. It is left to the reader to conceptualize why as in our example, selling JPY forward versus USD derives a differential gain while buying JPY forward would result in a relative loss. (Hint: Rates are higher in US than in Japan.) COVERED INTEREST RATE ARBITRAGE ~ The forward rate is the rate at which the counterparties will execute the future currency exchange. This rate is based solely on the interest rate differential between the currencies and is derived so as to eliminate any possible arbitrage opportunities between the spot and interest rate markets. It is important to conceptualize that the forward FX, spot FX, and credit market prices are mutually consistent. The prevailing forward rate will guarantee that the initial net present value of the forward contract is zero; thereby ensuring the inter-market consistency. This relationship is known as covered interest rate arbitrage (Exhibit Two below). Exhibit Two: Covered Interest Arbitrage
Transactions in Japan 100 million JPY USD/JPY Spot @ 129.00 Transactions in US $775,194

Invest in Japan @ 0.6953% for 1 Year

Invest in USD @ 5.9375% for 1 Year

Receive 100,695,300

USD/JPY 1Y FWD @ 122.62

Receive $821,221

We can see that the forward rate links the future value of two currencies just as the spot rate reflects their present value. At a USD/JPY spot rate of 129.00 and the respective risk-free rates of USD and DEM at 5.9375% and 0.6953%, the forward rate is set at 122.62. In an efficient market, this relationship holds. There is no arbitrage opportunity. COVERED INTEREST RATE ARBITRAGE: A PRACTICAL EXAMPLE ~ Suppose a US company expects to receive 100 million JPY in one years time. They can hedge the incoming flow and thereby lock in the USD value of their exposure by entering a 1year forward contract.
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We can evaluate the merits of such a decision by considering alternative transactions that would be required in order to synthesize this forward contract. The company would have to 1) borrow 100 million JPY for one year at the local risk-free rate, 2) convert the yen to USD at the current spot rate, 3) invest the proceeds at the US risk-free rate for one year, and 4) convert the Dollar proceeds to JPY and repay the loan. Covered interest rate arbitrage says that the total return of this process is identical to that of executing the outright forward, as Table One illustrates: Table One: Transaction Summary
Transaction 1. Borrow 100 million JPY for 1 year at 0.6953% hedge interest payment at the forward rate 2. Convert 100 million JPY to USD at spot rate 3. Invest $775,194 for 1 year at 5.9375% 4. Repay the Japanese loan NET position: Interest Paid / Received <JPY695,300 /USD5,693> $46,027 <JPY695,300 /USD5,693> $40,334

Then net gain above is in fact identical to the cost of hedging earned by selling JPY forward for one year (100,000,000 / 129.00) - (100,000,000 / 122.62). This example helps us appreciate the non-arbitrage characteristic of the forward market. In fact, one could further argue that because borrowing at the risk-free rate is not really possible, forward hedging will generally be a lower cost hedging alternative to foreign borrowing. PRICING ~ The following formula is used to calculate the outright forward rate given the spot exchange rate and the corresponding risk-free interest rates.
Formula 1: Outright Forward Rate F= Forward Rate S = Spot Rate 1 + Iv T If = Interest Rate of Fixed Currency ) F = S( 1 + If Iv = Interest Rate of Variable Currency T = Time to Contract Expiry

The forward points can be calculated using the following formula. S = Spot Rate as Market Quoted If = Interest Rate of Fixed Currency Pts = D Iv = Interest Rate of Variable Currency ( If 365) +1 D = Days to Maturity Forwards deal at either premiums or discounts. Premium forward points must be added to the spot rate, making the forward rate higher than the spot rate. Discount forward points must be subtracted, of course making the forward rate lower. If you want to buy the fixed currency versus the variable currency forward, then premium points work against you, meaning that if you want S D ( Iv If ) 365
3 Formula 2: Forward Points

to sell the fixed currency forward, premium points work in your favor. The conditions are reversed for discount points. The difference here represents the interest rate differential that intrinsically is paid or received. This differential is also known as the cost of carry. As an example, lets suppose a company is interested in buying USD forward versus ITL, with USD/ITL spot rate @ 1620.00 and the 6-month forward points quoted @ 1175. In this case we want to buy the fixed currency and sell the variable currency. The premium forward points make the forward rate less attractive. As another example, lets suppose a company is interested in selling GBP forward versus DEM. The cross rate is quoted as GBP/DEM therefore the fixed currency is GBP and the variable currency is DEM. Discount forward points again work against us, as we are selling the fixed currency forward. A PRICING EXAMPLE ~ Now suppose another US company needs to make a payment to a German supplier in 6 months. To eliminate uncertainty, the firm locks in a rate today. We will subscribe to the preceding formula to illustrate how the forward points are derived. The company needs to buy a DEM forward, so the forward differential in this case works against us. The current spot rate is 1.7830 / 40, the 6 month Euro-DEM bid rate is 3.83594%, the Euro-USD offer rate is 5.90625%, and the contract will mature in 180 days. (Please note that the interest rates are quoted NOT as percentages but in decimal form). Formula Three: Forward Points

Pts =

180 ( 00383594 00590625 ) . . . 17830 360 180 ( 00590625 360 ) +1 .

= 179

The 6-month forward points are then quoted at -185 / -175. In 6 months, we will be purchasing JPY, so we are on the bid side of the market. If we take the spot rate and the respective 6-month forward points, we can arrive at the outright forward rate. The calculation is as follows. Formula Four: Outright Calculation
Bid / Ask Spot Rate 6M FWD Pts. 1.78 30 / 40 -185 / -175

1. 7 8 3 0 - 0. 0 1 8 5 1. 7 6 4 5

Special attention must be paid in order to properly add or subtract forward points. As a general rule, the spot rate and forward points should be right justified before carrying out the simple arithmetic. Naturally, discount forward points are subtracted from the spot as in this case; whereas premium forward points are added to spot. RISKS ASSOCIATED WITH FORWARD CONTRACTS ~
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Two types of exposures arise upon entering a forward contract. One comes from forecast error and the other comes from financial accounting practice. These are essential to consider because although a forward contract eliminates currency risk, it does not eliminate all risk. We will now discuss further. When exposures transform from anticipated to commitment, there will be some residual risk resulting from forecast error. If the actual exposure is greater (less) than expected, the firm will be underhedged (overhedged). Even if the forecast and actual figures are identical, firms may still be subject to risk in the form of a timing mismatch. This would arise when flows do not occur when expected, and so for instance, delays in receipt / disbursement schedules can also result in a firm being under or over its forecast. Whether there is a mismatch in magnitude or timing, a firm may need to enter the spot market to meet its obligations. In this case the direction of the dollar decides whether or not the firm has experienced a loss. In addition, current financial accounting standards dictate that if a company uses a forward contract to hedge an anticipated exposure, then the change in value of that forward must be reported at the mark-to-market value on a quarterly basis. So even if the forecast error is zero, the value of that forward contract may change through time, and those gains / losses must pass through the income statement at quarters end. The danger lies in the fact the value of the underlying exposure may not be realized until sometime after that. This may lead to unfavorable swings in reported earnings. MARK-TO MARKET A FORWARD CONTRACT ~ Previously we looked at an example where a US company buys DEM six months forward. Recall the spot at the time of execution was 1.7830 and the 6-month points were -185. Now further suppose that this contract was executed on 2/1/xx. The company sold 10 million DEM and bought $5,667,328 USD. On 3/31/xx, the date marking the end of the quarter, the company is obliged by the FASB to mark-to-market that forward. You will note that this contract will expire in 4 months. Intuitively, marking-to-market a derivative instrument is determining how much it would cost to unwind or liquidate the contract. In order to unwind our original forward, we would need to carry out the reverse operation. We would re-enter the forward market, and this time sell a DEM forward for delivery on the date the original forward expires, for the amount of the original contract, at the new contract rate. Then we would compare the original USD position of $5,667,328 versus the USD position under the second forward contract. The difference between both of these dollar amounts is the realized gain / loss on the forward, which would consequently pass through the balance sheet. Let us look at a mark-to-market example. Suppose the USD / DEM spot rate at quarter end will be 1.7000 / 10 and the 4-month forward points quoted at -151 / -141. In order to mark-to-market our original forward position, we must consider the USD effect of selling 10 million DEM forward @ the 4-month forward rate of 1.6869. This would produce an artificial gain of $260,706 which would pass through the financial statement ($5,928,034 - $5,667,328). It is an artificial gain only because the offsetting underlying position would of course show a loss. Table Two shows a summary of transactions.
Table Two: Summary of Transactions Initial Forward Contract DATE 2/1/xx 5 Mark-to-Market 3/31/xx

MATURITY RATE BUY SELL

6 months 1.7645 10 million DEM $5,667,328 USD

4 months 1.6869 $5,928,034 USD 10 million DEM

Although this represents a loss, it is not an economic loss to the firm. This is because a loss on a forward contract is offset by a gain on the underlying asset. Mark-to-market transactions, however, still possess the undesirable attribute of introducing earnings volatility into a companys books. This is a type of risk which should be acknowledged. NON-DELIVERABLE FORWARDS ~ For traditional forward contracts, there is actual physical delivery of the underlying currencies. For instance, if a company sells JPY / buys USD forward for 6 months, this means that upon contract expiry, the company will actually deliver the notional JPY amount and in return will receive a corresponding amount of dollars. Forward contracts of this type are available for currencies which are liquid and have no convertibility restrictions. Some examples are JPY, GBP, DEM, AUD, etc.. However, there are of course currency regimes with limited exchange rate and interest rate markets. This is evident in such emerging market countries of southeast Asia, eastern Europe, and Latin America where often local governments, to some degree, restrict business access to off-shore entities. Is it possible then that hedging tools exist for such currencies? WHAT IS A NON-DELIVERABLE FORWARD? ~ Non-deliverable forwards (NDFs) operate very much like traditional forward contracts with the exception that there is no physical delivery of funds. Instead, the contract is cash-settled in USD at expiration. NDFs offer to a certain extent the same hedging and investment capabilities that traditional forward contracts offer. Their existence makes it possible for offshore participants to manage the currency risk of doing business in a number of developing economies, even where there is little or no direct access to the local currency market.
Table Three: Examples of currencies which offer NDFs Latin America Southeast Asia Eastern Europe Argentine peso Chinese renminbi Czech koruna Brazilian real Chilean peso Colombian peso Venezuelan bolivar India rupee Philippine peso South Korean won Taiwan dollar Hungarian forint Russian ruble Polish zloty Slovakian crown

PRICING ~ The forward rate is the rate at which both parties execute the future currency exchange. For traditional forward contracts, this rate is based solely on the interest rate differential between both currencies and is derived so as to eliminate any arbitrage opportunities that may exist between spot and interest rate markets. This rule does not necessarily hold for NDFs.
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The NDF forward market as a whole is somewhat illiquid and there may be restrictions on the notional size and maturity of the contracts. The NDF forward rates then are not entirely based on interest rate differentials as they are with highly liquid and easily convertible currencies as the German mark and the Japanese yen. The NDF market is supply and demand driven as the rates are more generally set on an implied market perspective rather than an arbitrage relationship. EXAMPLE ~ Suppose a USD functional company USA inc. was set to receive 300 million Korean won in 3 months time. The company recognizes the importance of currency risk management and so would like to hedge their exposure with a non-deliverable forward. The contract specifications are as follows: Table Four: Contract Specifications
Contract Date Spot rate 3M Forward Rate KRW sold USD bought 9/2/xx 905.00 1065.00 300,000,000 $281,690

This means that USA inc. has assured themselves a USD value of $281,690 for their forthcoming receivable. However, because this is not a traditional forward contract, USA inc. will not deliver the 300 million KRW to the bank. Instead, at contract expiry, they will sell the won on the spot market. Any gains or losses incurred relative to the execution rate of 1065.00 will be USD cash-settled between USA inc. and the bank. Let us illustrate. Suppose that the USD / KRW spot rate at contract expiry is 1188.00. USA will conduct the following two transactions: Table Five: Sample Transactions
Transaction 1. Spot settlement 2. Forward settlement Transaction (300,000,000) / 1188.00 $281,690 - (300,000,000 / 1188.00) NET position: USD amount $252,525 $29,165 Result Economic loss Economic gain / cash settlement

$281,690

As you can see, USA inc. successfully hedged their position against further KRW depreciation. Non-deliverable forwards are conceptually very much the same as the standard instrument, the only difference is found upon settlement. Non-deliverable forwards are of key interest to companies with foreign operations in emerging market areas. As the recent turmoil in Asia has illustrated, it is important to consider the hedging and funding capabilities available. SWAPS ~ A swap contract involves the simultaneous execution of a forward and a spot transaction. They also play an important role in corporate risk management.
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As we know, foreign exchange forwards are commitments to exchange currency on a future date, at a predetermined rate of exchange. Once a party enters a forward, they are obliged to execute according to its terms. However, what if a company needs to transact earlier or later than the maturity date of the contract? It is possible to extend or unwind a forward contract by executing a swap. The details are as follows. EXTENDING A FORWARD HEDGE ~ Suppose on 6/1/xx, a company SWA entered a strip of forward contracts to hedge anticipated receivables according to the schedule below. Spot is 1.7000. Table Six: Project Flows
Schedule Date DEM Receivable Forward Rate

7/1/xx 8/1/xx 9/1/xx

15 million 10 million 5 million

1.6962 1.6924 1.6886

Further suppose that production delays will cause the flows to arrive 2 weeks later than expected. This means that SWA will not have the DEM necessary to meet the pending forward obligations and as a result must swap the forwards out to the new expected arrival dates. Let us consider the first receivable as an example. On 7/1/xx, SWA has not received payment of 15 million DEM. Therefore, they must buy 15 million DEM spot to settle the original forward, and subsequently enter a new forward out to 7/15/xx. This will cover the forthcoming cash flow. Spot is 1.7500 and the 14 day forward rate is 1.7481.
Table Seven: Extending the FWD on 7/1/xx
DEM USD

1. Settle original FWD

Buy 15 mil spot @ 1.7500 Deliver 15 million

Pay $8,571,429 Receive $8,843,297 Cash Flow +$271,868 Receive $8,580,745 FWD +$9,316

2. Enter a new FWD

Sell 15 mil @ 1.7481 FWD Net Position

As a result of the forward swap (step 1), SWA will experience a cash flow gain of $271,868 ($8,843,297 - $8,571,429). This however, is not an economic gain. When SWA enters into the new forward contract, they will only receive $8,580,745. When the entire series of transactions (steps 1 and 2) are netted, the result is a gain of $9,316 ($8,580,745 + $271,868 $8,843,297) when compared to the original forward. This gain comes from the additional interest rate carry that was obtained by selling DEM forward for an additional two weeks. Now suppose 7/15/xx comes and funds still have not arrived. SWA again may swap the pending forward out to another future date, assuming no economic loss relative to the original position but incurring the forward spread for the additional period. UNWINDING A FORWARD HEDGE ~
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Now let us assume that SWA receives the last flow of 5 million DEM scheduled to arrive on 9/1/xx, 2 weeks earlier than expected. Two alternatives arise. SWA can leave the funds in a German account until the expiry date of the forward, thereby earning interest for two weeks. Alternatively, SWA can execute a swap upon receipt of the funds and record the cash flow two weeks early. The mechanics of this swap transaction are slightly different as we are unwinding the forward before it is due rather than after. The following is a summary of the transactions. Table Eight: Unwinding the FWD on 8/15/xx
DEM USD

1. Repatriate DEM 2. Enter a new FWD

(9/1/xx)

(8/15/xx)

Sell 5 mil spot @ 1.7200 Buy 5 mil @ 1.7183 FWD Deliver 5 million Net Position

Receive $2,906,977 Cash Flow + $2,906,977 Deliver $2,909,853 FWD Receive $2,860,248 -$2,876

(8/15/xx)

3. Settle original FWD

Note that on 8/15/xx, we are repatriating the DEM receivable and entering into a new contract where we buy 15 million DEM forward to the maturity date of the original forward. The DEM receipt is used to deliver against our original contract. In this situation, the swap points are working against us, as we are buying DEM forward. The net USD position versus the original position is -$2,876, an amount equivalent to the interest carry we pay on the second leg of the swap. Swap transactions are an effective way to extend or unwind a forward hedge while continuing to protect forthcoming exposures. However, swaps do possess one unattractive attribute; the cash flow effect. Currency fluctuations will dictate whether a company will experience a positive or a negative cash flow when executing a swap. Nevertheless, this element does introduce earnings volatility, as gains/losses are realized on the date of the swap.