Question on Forward Contract
Discussion
An exercise for college has me scratching my noggin.
This is from the point of view of a UK co. receiving payment from a U.S. firm, and you are trying to eliminate FX risk for the UK company.
"An American company will pay $3m in 3 months, show how FX risk can be eliminated using forward market and money market cover"
The spread is $1.7680/£ - $1.7690/£ and the 3 month forward premium is 1.56 - 1.51
Interest Rates are 15/13% in London for Borrowing/Lending
Interest Rates are 10.5/8.5% in New York for Borrowing/Lending
My answer for the forward market cover part would be selling the $3m forward at the ask rate (discounting the premium) so...
$3m/1.7539 = £1,710,473.80
have we essentially eliminated risk by guaranteeing we'll receive less money in 3 months by 'locking in' in the future exchange rate of 1.7539? Do I find the cost of this transaction by subtracting the current spot ask rate from this figure? So £1,710,473.80 - £1,695,873.38 = £14,600.43
So because an American company doesn't pay us now and pays us 3 months from now we take a not insubstantial hit, just to make sure that the risk of the dollar appreciating even more in that same 3 month period isn't realised?
This is from the point of view of a UK co. receiving payment from a U.S. firm, and you are trying to eliminate FX risk for the UK company.
"An American company will pay $3m in 3 months, show how FX risk can be eliminated using forward market and money market cover"
The spread is $1.7680/£ - $1.7690/£ and the 3 month forward premium is 1.56 - 1.51
Interest Rates are 15/13% in London for Borrowing/Lending
Interest Rates are 10.5/8.5% in New York for Borrowing/Lending
My answer for the forward market cover part would be selling the $3m forward at the ask rate (discounting the premium) so...
$3m/1.7539 = £1,710,473.80
have we essentially eliminated risk by guaranteeing we'll receive less money in 3 months by 'locking in' in the future exchange rate of 1.7539? Do I find the cost of this transaction by subtracting the current spot ask rate from this figure? So £1,710,473.80 - £1,695,873.38 = £14,600.43
So because an American company doesn't pay us now and pays us 3 months from now we take a not insubstantial hit, just to make sure that the risk of the dollar appreciating even more in that same 3 month period isn't realised?
The forward value of one currency in terms of another is a function of today’s FX rate, adjusted for the relevant interest rates for the period in question. With the rates that are given you can, as you rightly say, sell the $3 mio forward at 1.7539, to eliminate any FX risk. The proceeds are £1,710,474
The alternative answer that you are expected to give is that you sell the USDollars TODAY and invest the sterling proceeds for 3 months. Of course you don’t HAVE any USDollars today, so you would need to borrow them, before selling them. That is why you are given the relevant interest rates for the two currencies in the question.
You borrow the NPV amount of $3 mio at an interest rate of 10.5% for 3 months, which is $2,923,264… you sell these USDollars today at 1.7690. The sterling proceeds are £1,652,495 and you invest this sterling for 3 months at an interest rate of 13%. In 3 months time you receive back £1,706,201 (including accrued interest) and you repay the loan of $2,923,264 + interest (which is $3 mio) with the $3 mio that you receive from the US firm.
As you can see there is a small difference between the two answers here, and this is probably a combination of 2 things. Firstly, the exercise is using round numbers for the interest rates (for ease) and secondly, in practice, interest on USDollars is calculated on a 360-day basis in the money markets, whereas sterling is calculated on a 365-day basis. Without knowing the exact number of days that “3-months” is, in this exercise, its impossible to be more specific with the answer.
I hope that helps.
The alternative answer that you are expected to give is that you sell the USDollars TODAY and invest the sterling proceeds for 3 months. Of course you don’t HAVE any USDollars today, so you would need to borrow them, before selling them. That is why you are given the relevant interest rates for the two currencies in the question.
You borrow the NPV amount of $3 mio at an interest rate of 10.5% for 3 months, which is $2,923,264… you sell these USDollars today at 1.7690. The sterling proceeds are £1,652,495 and you invest this sterling for 3 months at an interest rate of 13%. In 3 months time you receive back £1,706,201 (including accrued interest) and you repay the loan of $2,923,264 + interest (which is $3 mio) with the $3 mio that you receive from the US firm.
As you can see there is a small difference between the two answers here, and this is probably a combination of 2 things. Firstly, the exercise is using round numbers for the interest rates (for ease) and secondly, in practice, interest on USDollars is calculated on a 360-day basis in the money markets, whereas sterling is calculated on a 365-day basis. Without knowing the exact number of days that “3-months” is, in this exercise, its impossible to be more specific with the answer.
I hope that helps.
pilbeam_mp62 said:
You borrow the NPV amount of $3 mio at an interest rate of 10.5% for 3 months, which is $2,923,264… you sell these USDollars today at 1.7690. The sterling proceeds are £1,652,495 and you invest this sterling for 3 months at an interest rate of 13%. In 3 months time you receive back £1,706,201 (including accrued interest) and you repay the loan of $2,923,264 + interest (which is $3 mio) with the $3 mio that you receive from the US firm.
Thanks for the replies, in particular Pilbeam! A quick question on using the money market to eliminate risk, these are the steps I'm working through from your replies1. Borrow equivalent NPV of $3million = $2,923,264, repayment in three month is $3million
2. Buy sterling spot using the $2,923,264 = £1,652,495
3. Invest/lend sterling for 3 months at 13%, in 3 months this equals £1,706,201
4. £1,706,201 in dollars in 3 months = $2,989,946 (using forward bid rate)
5. Pay off loan with $3million from US firm, we are left with $2,989,946?
I'm getting confused here, did we just borrow dollars to hedge against the risk of not getting paid at all? How are we eliminating FX risk?
Edited by daveco on Thursday 17th October 20:11
You need to be clear in your mind of the definition of the risk that you are being asked about in this question. "FX Risk" is the risk that the countervalue of the currency that you own (or will own in the future) changes from its value now.
The risk that the US company does not pay the $3 mio is entirely different, and is not being considered in the question. In practice, if the US company failed to deliver the $3 mio in 3 months time then you would have to do the equal and opposite transaction to flatten your position. i.e you would Sell sterling and Buy $ 3 mio at the prevailing spot rate in 3 months time. If sterling had weakened in that period, then YOU would suffer a loss.
You also need to understand that the forward values of currencies are NOT a predictor of where the FX rate will move over time - this is a basic mistake that newcomers to the wonderful world of FX can sometimes make. The forward values (as I mentioned in my earlier post) are simply a function of todays rate and interest rates. Therefore, in the scenario where the US company defaults on their payment of $3 mio, you could suffer significant loss, if the rate had moved down to, say, 1.6500 during the 3 months.
The risk that the US company does not pay the $3 mio is entirely different, and is not being considered in the question. In practice, if the US company failed to deliver the $3 mio in 3 months time then you would have to do the equal and opposite transaction to flatten your position. i.e you would Sell sterling and Buy $ 3 mio at the prevailing spot rate in 3 months time. If sterling had weakened in that period, then YOU would suffer a loss.
You also need to understand that the forward values of currencies are NOT a predictor of where the FX rate will move over time - this is a basic mistake that newcomers to the wonderful world of FX can sometimes make. The forward values (as I mentioned in my earlier post) are simply a function of todays rate and interest rates. Therefore, in the scenario where the US company defaults on their payment of $3 mio, you could suffer significant loss, if the rate had moved down to, say, 1.6500 during the 3 months.
daveco said:
Thanks for the replies, in particular Pilbeam! A quick question on using the money market to eliminate risk, these are the steps I'm working through from your replies
1. Borrow equivalent NPV of $3million = $2,923,264, repayment in three month is $3million
2. Buy sterling spot using the $2,923,264 = £1,652,495
3. Invest/lend sterling for 3 months at 13%, in 3 months this equals £1,706,201
4. £1,706,201 in dollars in 3 months = $2,989,946 (using forward bid rate)
5. Pay off loan with $3million from US firm, we are left with $2,989,946?
I'm getting confused here, did we just borrow dollars to hedge against the risk of not getting paid at all? How are we eliminating FX risk?
FX risk is hedged by doing the spot trade, that's the only way. Note that you could do the full amount to hedge all FX risk, but many treasurers may take a view depending on how they felt spot will move or will do half the amount and see what happens. It's down to your risk appetite and your knowledge of that market.1. Borrow equivalent NPV of $3million = $2,923,264, repayment in three month is $3million
2. Buy sterling spot using the $2,923,264 = £1,652,495
3. Invest/lend sterling for 3 months at 13%, in 3 months this equals £1,706,201
4. £1,706,201 in dollars in 3 months = $2,989,946 (using forward bid rate)
5. Pay off loan with $3million from US firm, we are left with $2,989,946?
I'm getting confused here, did we just borrow dollars to hedge against the risk of not getting paid at all? How are we eliminating FX risk?
Alternative to FWD FX explained
Day one you want to buy GBP and sell USD spot. You don't have any USD so you borrow $2.923,264 at 10.5% for three months. That USD amount converted into GBP gives you £1,652,495. To compare apples with pears you lend it for three months at 13% to see what that it would be worth in three months. Interest is £53,706 which gives a total of £1,706,201. This is less than what you would get if you traded spot and did a fwd fx trade which gives you £1,710,474.
In three months time you get your GBP capital and interest back. You need to pay back the USD you borrowed - $2,923,264 plus $76,735 interest makes a total of $3,000,000 which your customer is conveniently paying you on the same day. You hope...
Edited by keith333 on Friday 18th October 14:44
Morning chaps, second assignment given on this one. All figures are the same except we are a UK firm paying a U.S. firm $3million in 3 months.
Here's what I have;
1. Eliminating FX Risk using the Forward Market
-Subtract premium
$1.7680/£ - $1.7690/£
-0.0156 -0.0151
$1.7524 $1.7539
We buy $ @ forward bid rate from bank: $3million ÷ 1.7524 = £1,711,938
2. Eliminating FX Risk using the Money Market
-Find current NPV of $ you need to lend/invest to pay off $3million in 3 months
$3million ÷ (1+0.085/4) = $2,937,577
-Borrow £ equivalent, $2,937,577 ÷ 1.7680 = £1,661,525
-Convert sterling to dollars £1,661,525 x 1.7680 = $2,937,577
-Invest/lend $ in U.S. $2,937,577 x (1+0.085/4) = $3,000,000
-Repay £ loan £1,661,525 x 1+0.15/4) = £1,723,832 = cost
Forward market cover is cheaper.
Here's what I have;
1. Eliminating FX Risk using the Forward Market
-Subtract premium
$1.7680/£ - $1.7690/£
-0.0156 -0.0151
$1.7524 $1.7539
We buy $ @ forward bid rate from bank: $3million ÷ 1.7524 = £1,711,938
2. Eliminating FX Risk using the Money Market
-Find current NPV of $ you need to lend/invest to pay off $3million in 3 months
$3million ÷ (1+0.085/4) = $2,937,577
-Borrow £ equivalent, $2,937,577 ÷ 1.7680 = £1,661,525
-Convert sterling to dollars £1,661,525 x 1.7680 = $2,937,577
-Invest/lend $ in U.S. $2,937,577 x (1+0.085/4) = $3,000,000
-Repay £ loan £1,661,525 x 1+0.15/4) = £1,723,832 = cost
Forward market cover is cheaper.
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