3. Outright forwards

International Financial Services 1

Karel Bruna

Main Business Problems(outright forwards)

• Company and FX exposure based on simple transaction (static example)

• Outright forward as the main instrument how to lower FX exposure

• Pricing mechanism of outright forwards

• Pros and cons of outright forwards

Main Characteristics of Outright Forwards

Maturity: 1M, 2M, 3M, 6M, 9M, 12M + odd dates

Price: bid/ask forward rate (FR)

Currency pairs: as in case of spot contracts

Amount: minimum defined by the market maker

Interest Rates: interbank deposit/lending rates

yields of treasury instruments

Time conventions: act/360 or act/365

Forward Rate Quotation

Forward Rate Calculation and Quotation(outright quotation)

1 + IRUSD,D(t/360)FRBID(USD/EUR) = SRBID(USD/EUR) . ---------------------------

1 + IREUR,L(t/360)

1 + IRUSD,L(t/360)FRASK(USD/EUR) = SRASK(USD/EUR) . ---------------------------

1 + IREUR,D(t/360)

Forward Rate Calculation and QuotationExample of high points/low points quotation

spot rate quotation: BID ASK

SR (USD/EUR) 1,2393 1,2396money market quotation:

D L1M IREUR (% p.a.) 2,03 2,051M IRUSD (% p.a.) 1,08 1,11

outright forward rate calculation: 1 + IRUSD,D(t/360) 1 + 0,0108(30/360)FRBID = SRBID .---------------------- = 1,2393 .------------------------ = 1,2383USD/EUR

1 + IREUR,L(t/360) 1 + 0,0205(30/360) 1 + IRUSD,L(t/360) 1 + 0,0111(30/360)FRASK = SRASK .----------------------- = 1,2396 .------------------------ = 1,2387USD/EUR

1 + IREUR,D(t/360) 1 + 0,0203(30/360)

Forward Rate Calculation and Quotation(quotation in forward or swap points)

BID points:

(FRBID - SRBID) . 1000

(FRBID - SRBID) . 10000

ASK points:

(FRASK - SRASK) . 1000

(FRASK - SRASK) . 10000

Forward Rate Calculation and QuotationExample of high points/low points quotation

forward (swap) points calculation:

(FRBID - SRBID) . 10000 = (1,2383 - 1,2393) . 10000 = - 10 points(FRASK - SRASK) . 10000 = (1,2387 - 1,2396) . 10000 = - 9 points

outright forward quotation: BID ASK

FR (USD/EUR) 1,2383 1,2387forward (swap) points quotation:

USD/EUR 10/9spot exchange rate spread:(SRASK - SRBID) . 10000 = (1,2396 - 1,2393) . 10000 = 3 points

forward rate spread:(FRASK - FRBID) . 10000 = (1,2387 - 1,2383) . 10000 = 4 points

Forward Rate Calculation and Quotation

FR > SR base currency is at premium and quoted currency is at discount quoted as low points/high points

FRBID = SRBID + low pointsFRASK = SRASK + high points

FR < SR base currency is at discount and quoted currency is at premium

quoted as high points/low points

FRBID = SRBID - high pointsFRASK = SRASK - low points

Pricing Mechanism of Outright Forwards

• forward rate of standard forward contract

• implied forward rate of synthetic forward contract

Pros and cons of outright forwards

Arguments for outright forwards:

• Main instrument for FX exposure management

• Easy and cheap way how to obtain fixed exchange rate

• Possibility how to lower volatility of cash-flow

Arguments against outright forwards:

• Suitable only for transactions with known amount and maturity

• Suitable only for static examples of FX exposure