How is the price of an FX forward / Hedge calculated?

How is the price of an FX forward / Hedge calculated?
When an exporter ships goods to a client overseas, whether that is under an open account arrangement or via a letter of credit, the importer will often ask for extended terms which will allow them to settle the invoice at a pre-agreed time in the future.

As the exporter will have already manufactured and shipped the goods, they will be exposed to any fluctuation in the exchange rate between the time of invoice and the time of payment unless previously negotiated.

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The exporter exposed to any fluctuation in the exchange rate
A prime example of this risk is illustrated perfectly by the fluctuation in the value of Sterling between January and April 2018. If a UK exporter had invoiced his client in dollars on 10th of January, allowing him three months to pay, he would have calculated the dollar amount using a rate of around 1.3300. If he had received the dollars on 10th of April and not hedged, he would have sold them at a rate close to 1.4200. This accounts for a 6.75% difference in the total sum received by the supplier.

Say the invoice were for the equivalent of £10k, he would have invoiced for $13.3k, but when he received the dollars and sold them at 1.4200 he would only have received £9.36k, a loss of £640 or 6.75%.

This used to be considered a cost of doing business but businesses have now become more sophisticated in their management of risk.

There are two ways to mitigate this cost. The first is a little crude and not particularly effective. It is simply to increase the cost to the customer by a percentage amount to offset any exchange rate difference. This could make the product uncompetitive and probably lead to a loss of business.

A more equitable method is to sell to or buy from a payments platform such as CurrencyTransfer.com at the time of invoice for delivery on the due date under the agreed payment terms with your customer/supplier. In this manner the foreign exchange risk is mitigated.

CurrencyTransfer platform for importer and exporter
An FX forward rate differs from the spot (immediate delivery rate) by the difference in interest rates between the two currencies.

If you buy a currency today and place it on deposit, the interest rate you earn would be higher (or lower) than the currency you sold.

If you had done nothing, you would earn interest on your deposit in the original currency. However, by exchanging for another currency, you will earn more (or less).

To negate this opportunity to make a “risk free profit”, the rate for delivery today differs from the rate for future delivery, by the interest rates applicable
Example (graphic?)

Forward contract calculation example explained
Therefore 1.3082, is the rate for delivery in three month’s time.

The difference is normally expressed in points, so it is 82 points. If the dollar interest rate were lower than the Sterling interest rate, then the rate for delivery in 90 days would be lower as the points would be deducted.

Banks have never really wanted to clarify FX forward pricing, often building in various risk adjustments and spreads, but when broken down it is a relatively simple calculation.

The risk inherent in a forward FX transaction is not market risk, it is delivery risk and that is why an FX partner will want to take a margin at the time the deal is booked.

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About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”