I. The Concept and Role of Forward Foreign Exchange Transactions
A forward foreign exchange transaction is a type of transaction in which the buyer and seller of foreign currency enter into a contract in advance to settle the transaction at a specified future date. The foreign exchange contract specifies details such as the settlement date, amount, and exchange rate.Forward foreign exchange transactions can meet the needs of different investors; for example, they can be used for asset preservation, speculative gains, arbitrage trading, and more.
II. Quotation and Calculation of Forward Exchange Rates
Forward exchange rates can be quoted in two ways: direct quotation or spread quotation.
- A direct quote is when a bank directly quotes a forward exchange rate. For example, on the Zurich foreign exchange market, the three-month forward exchange rate for USD/CHF is 1 USD = 0.9608/15 CHF.
- A spread quote is when a bank quotes not the forward exchange rate, but the forward premium or discount. If the first figure is smaller and the second is larger, it is a premium; if the first figure is larger and the second is smaller, it is a discount.
For example, suppose the spot exchange rate on a given day is 1 U.S. dollar = 0.9560/70 Swiss francs:
If the three-month premium/discount is 20/30, then the three-month forward exchange rate is 1 U.S. dollar = 1 U.S. dollar = 0.9560 + 0.0020 /0.9570 + 0.0030 Swiss francs, or 1 U.S. dollar = 0.9580/0.9600 Swiss francs;
If the three-month premium/discount is 30/20, thenthe three-month forward exchange rate is 1 USD = 1 USD = 0.9560 – 0.0030 / 0.9570 – 0.0020 Swiss francs, i.e., 1 USD = 0.9530 / 0.9550 Swiss francs.
III. Applications of Forward Foreign Exchange Transactions
1. Value-preserving foreign exchange forward trading
Value-prepaid foreign exchange forward trading is the purpose of signing forward forex contracts in advance to avoid losses caused by exchange rate fluctuations to foreign exchange positions.
For example, in January 2022, a domestic company signed an export contract worth £1,000,000 with a British company, agreeing to receive payment in three months, expecting the RMB to appreciate against the pound. At that time, the spot exchange rate was 1 GBP = 8.4960/70 RMB, and the 3-month forward rate was 30/20. Three months later, the market spot rate was: 1 GBP = 8.4255/65 RMB. The exporter could avoid losses caused by exchange rate fluctuations through forward foreign exchange trading. The specific analysis is as follows:
For forward forex trading:
The forward exchange rate is: 1 GBP = 8.4930 / 50 RMB (8.4960 – 0.0030 / 70 – 20)
Foreign exchange settlement: 1,000,0008.4930 = 8,493,000 RMB If no forward foreign exchange transaction is conducted: the forward exchange rate is: 1 GBP = 8.4255 / 65 RMB Settlement: 1,000,0008.4255 = 8,425,500 RMB
Therefore, we can see that importers can avoid losses of 8,493,000 – 8,425,500 = 67,500 RMB when conducting forward foreign exchange hedging transactions.
2. Speculative foreign exchange forward trading
Speculative foreign exchange forward trading allows investors to profit by anticipating that the spot exchange rate at a given time will not match the current forward exchange rate.
For example, on a certain day in the Hong Kong foreign exchange market, the three-month forward exchange rate was 1 USD = 7.7822/41.A speculator expects the USD/HKD spot exchange rate to be 1 USD = 7.7944/51 three months from now. If this expectation proves accurate, how much profit would be made on an investment of 1,000,000 USD?
Step 1: The speculator buys 1,000,000 USD with a three-month maturity, expecting to pay 1,000,000 × 7.7841 = 7,784,100 HKD
Step 2: Three months later, the investor sells the $1,000,000 and receives 1,000,000 × 7.7944 = 7,794,400 HKD.
Therefore, the speculator earns 7,794,400 – 7,784,100 = 10,300 HKD
3. Arbitrage Trading
Arbitrage trading is a method of generating returns by shifting funds from a low-interest-rate environment to a high-interest-rate environment based on the difference in interest rates between two currencies.However, the process of transferring funds from one country to another involves the risk of exchange rate fluctuations. Entering into a forward foreign exchange contract in advance can mitigate this risk, effectively serving as “insurance” for the arbitrage transaction. In professional terms, this is known as hedged arbitrage—using one instrument to offset the risk exposure.
For example, in early March, the U.S. interest rate was 1.2%, the U.K. interest rate was 3.6%, the spot exchange rate was 1 pound = 1.3525/35 dollars, and the 6-month forward premium/discount was 50/40.and six months later, the spot exchange rate in the market is 1 British pound = 1.3420/30 U.S. dollars. How much profit would an investor make on a $1 million investment?
If no cover-and-carry arbitrage is conducted:
Exchanging U.S. dollars for British pounds in early March: 1,000,000 / 1.3535 = 738,825.27 pounds
Total principal and interest on the British pounds invested for half a year:738,825.27 × (1 + 3.6% / 2) = 752,124.12 GBP. Converting the pounds back to dollars at the spot exchange rate after six months:752,124.12 × 1.3420 = 1,009,350.576 USD
Therefore, a non-hedged arbitrage would yield a profit of 1,009,350.576 – 1,000,000 = 9,350.576 USD.
If a “sell-and-buy-back” arbitrage is conducted:
In early March, exchange the U.S. dollars for British pounds: 1,000,000 / 1.3535 = 738,825.27 British pounds
Total principal and interest on the British pounds invested for half a year: 738,825.27 × (1 + 3.6% / 2)= 752,124.12 GBP. Convert the pounds back to dollars at the agreed-upon forward exchange rate after six months: 752,124.12 × (1.3525 – 0.0050) = 1,013,487.252 USD
Therefore, engaging in carry trade arbitrage yields a profit of 1,013,487.252 – 1,000,000 = 13,487.252 USD, which is 4,136.676 USD more than the profit from a non-carry trade.This is because, in this arbitrage example, the exchange rate of the British pound declined over the 6-month period, exposing the arbitrage activity to exchange rate losses; however, by using a forward foreign exchange contract, the exchange rate risk was locked in, thereby maximizing the profit from the arbitrage.
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