Summary
Transaction made based on the agreement to trade a specific currency at a specific FX rate, on specific time in future,
and of which settlement date is fixed from the 2nd day from the trade date (within 1 year, in general)
cf. Its concept should be distinguished from Futures of which product is standardized and its trade is done on the exchange
cf. Its concept should be distinguished from Futures of which product is standardized and its trade is done on the exchange
Objectives of Forward Transaction
- FX risk hedging on international trade
- - Generally, there is a time gap between the contract trade date and the settlement date. As such time gap exists,
in order to hedge the FX risk during this period, Forward Transaction should be used.
If a Korean importer has to make a settlement for the imported goods after 3 months, one can avoid the risk from FX fluctuation for that 3 months period by fixing the FX rate for the settlement through Forward transaction with 3 months maturity at the time of making the trade contract. - FX risk hedging on the trading of capital
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- When the company has a borrowings in foreign currency from abroad, if the FX rate at the time of redemption moves higher than the one at the time of borrowing,
the redemption amount in Won currency will increase to redeem the borrowings and the company will suffer from that increased burden.
Accordingly, the company can avoid the FX risk by fixing the FX rate at the time of redemption through Forward biding contract to US Dollar at time of the borrowing. - Arbitrage
- - In the case when a temporary mismatching of FX rate and interest rate takes place. Forward transaction is used to get a marginal profit from this mismatching at no risk.
- Speculation
- - From an aggressive motivation, Forward transaction can be used to get the profit without any self-financial burden by utilizing FX rate fluctuation expected in future. However, when the prediction of the future rate is not correct, the loss resulted from such mistake should be put up with.
Type of Transactions
- - Standard Date: 1 month, 2 months, 3 months, 6 months, and 1 year
- - Broken Date: reduce the number of days from the Forward FX price of Standard Date transaction by using interpolation.
Transaction Method
- - Ceiling transaction: transactions within the limit secured by Collateral or Credit
- - Key money transaction: transactions, after paying a certain rate of Key money set by the bank
At this time, the key money is received by the bank to gurantee the customer’s execution of a contract and it will be refunded to the customer after the settlement of Forward contract at the maturity.
Available service hours
- - 09:00~15:00
※ NDF(Non Deliverable Forward, Discrepancy Settlement Forward)
- Concept
- - Unlike Forward that exchanges the contracted principal at the time of the maturity, NDF is the deal to settle the amount of difference between the contracted Forward FX rate and Spot FX rate at maturity.
- Background & Development
- - It was developed in Hong Kong, Singapore, London, and New York markets, in order to hedge FX risks and make speculations on the currencies of which, capital transaction is limited and international liquidity is lacking, such as THB, KR, CNY, etc.
- - vIn the case of KRW, its transaction volume has increased in a need for FX hedging, as the possiblity of Won currency growing strong, increased due to the extension of foreign stock investment limit. And, as Speculation has been increased in line with the liberalization of Forward transactions by local FX bank and non-residents on April 1999, total NDF transaction volume also increased.
- - As only the different amount is to be settled at maturity, the settlement risk at maturity is relatively lower than that of the general Forward contract, making it beneficial for Speculation.
- - In general, Spot FX rate at the maturity is based on benchmarking FX rate on the previous business day from the maturity date. (Market average FX rate on the date of 2 business days previous the maturity date)
※Swap Rate(Forward Rate) calculation formula and example
- - According to Interest Rate Parity Theory, which provides that the capital can move freely between the countries and there are no charges, such as transaction cost and tax, etc., the difference between Spot FX rate and Forward FX rate will be determined by the interest rate differences between two countries.
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· Forward FX rate > Spot FX rate: Base currency is at the state of Forward Premium Base currency is the currency of interest rate lower than that of the counter currency and it will be compensation to the currency of the lower interest rate
· Forward FX rate < Spot FX rate: Base currency is at the state of Discounted Forward FX rate Base currency is the currency of interest rate higher than that of the counter currency and it will be a burden to the currency of the higher interest rate
- - Deriving the Formula
Deriving the Formula
Provided that an investor has 1USD and the principal will be same regardless of which country to invest. Here, assume the investor will invest to US and Japan. In the case when to investing 1USD at the yield of Rf for d period in US, the principal is,1USD X (1 + Rf X d/360) ----------------- 1)
After converting 1USD to Japanese Yen and investing it at the yield of rv in Japan, convert it at Forward FX rate. In such case, the principal is,
1USD X S(1 + rv X d/360)/F ------------- 2)
S : Spot FX rate of USD/JPY
F : Forward FX rate of USD/JPY
As the formula of 1) and 2) should be the same,
1USD X (1 + Rf X d/360) = 1USD X S(1 + rv X d/360)/F
Accordingly, F = S X (1 + rv X d/360) / (1 + Rf X d/360) ---------------3)
Subtract S from both sides of 3) formula and get Swap Rate (SR):
Swap Rate(SR) = F - S = S X {(rv - Rf) X d/360} / (1 + Rf X d/360) --------------- 4)
Since the denominator (1 + Rf X d/360) of 4) formula is nearly close to 1, it can be simplified as below.
Swap Rate(SR) = F - S = S X {(rv - Rf) X d/360} ----------------- 5)
On 4) formula, if Rf > rv, the base currency is the currency of higher interest rate and it becomes Forward Discounted currency,
If Rf < rv, the base currency is the currency of lower interest rate and it becomes Forward Premium currency.
Example
USD 3 months (90 days) Term Deposit Interest Rate : 3.5%
JPY 3 months(90 days) Term Deposit Interest Rate : 0.1%
Spot Rate is USD/JPY = 120.10
If to use 4) formula In order to get 3 months Forward FX rate (F),
SR = F - S = 120.1 X {(0.001 - 0.035) X 90/360} / (1 + 0.035 X 90/360) = -1.02
As a result, 90 days Forward FX rate (F) is S + SR = 120.10 + (-1.02) = 119.08
cf) if to use the simplified formula 5),
SR = F - S = 120.1 X {0.001 - 0.035) X 90/360} = -1.03
F = S + SR = 120.10 + (-1.03) = 119.07
Therefore, there will be no big difference in the result when using the formal formula and that of the case when using the simplified formula.
