1. Home /
2. Trending Topics /
3. Forward exchange rates and their...

Forward exchange rates and their impact on returns

Will your returns suffer if your currency risk is hedged with foreign exchange contracts? Not necessarily, but it’s important to look at the full picture....

21 Feb 2019

Share on

As we’ve shown with an example in our previous blog, from a theoretical perspective, a forward exchange rate is dependent on the interest rate difference between the two currencies involved. As a result, risk-free arbitration to profit from interest rate differences on financial markets is impossible. In this blog, we dive a little deeper and investigate the difference between the yield of the currency being hedged and the return of a currency investment (foreign currency deposit).

How do you calculate the result of a forward exchange contract?

In the previous blog, we concluded that the forward rate is determined by the difference between the spot rate and the interest rate of two currencies (a currency pair). If the interest rate is higher, the forward rate of a currency is lower and vice versa.

However, the yield of a forward exchange contract is determined by the difference between the forward rate, agreed when buying or selling the forward, and the spot rate at the end of the contract term.

It works like this: let's say we want to invest £100 million in US Dollars and in 12 months' time we want to convert the amount back into Sterling. In that case, we buy a forward exchange contract to fix the future exchange rate when converting the US Dollars back into Sterling in 12 months. By doing this we hedge the 12 months currency risk that would be in the transaction if there was no forward. The forward exchange contract gives the exact exchange rate at which we’re able to exchange the US Dollars back into Sterling after 12 months.

An example

To calculate the yield of a forward exchange contract, we’ve included an example below based on the situation described above. As in our previous blog, we have used the rate data as of 23 January 2019.

 12-month Libor 1.158% 12-month USD Libor 3.037% Spot rate USD/GBP (at the start of the contract term) 1.3069 Forward rate 12-month USD/GBP (in accordance with the calculation) 1.3389 Spot rate (at the end of the contract term) 1.3750*

* Please note that this spot rate is indicative as the spot rate after a 12-month period after 23 January 2019 is unknown

In this example, we assume a forward exchange contract with an underlying value of \$130.69 million (£100 million x 1.3069 - the spot rate) this is the currency risk of a USD deposit on the 23rd of January. The USD is sold over a 12-month term. At the end of the term, the spot rate of the GBP/USD at which the contract is settled, has risen to 1.3750. The US Dollar is therefore worth less compared to Sterling. For every \$1.3750, you now get £1.00, whereas it was \$1.3069 = £1.00 at the start of the term. From this, we can conclude that the exchange rate of the US Dollar has fallen and thus the forward exchange contract yields a positive result of £2.56 million (\$130.69 million / \$1.3389) – (\$130.69 million / \$1.37500).

Interest revenue vs forward yield

The total result (£2.56 million) or yield of the forward contract is less than the impact of the fall in the US Dollar on the value of a deposit placed for 12-months at the USD-Libor deposit rate, as we will show.

The deposit of \$130.69 million has a value of £100 million at the start of the deposit (GBP/USD of 1.3069). At the end of the deposit term, the value has dropped to £95.05 million (\$130.69 million / \$1.3750). This represents a loss in value of £4.95 million. This loss is £2.39 million more than the profits under the forward exchange contract as the positive result of the forward was £2.56 million, mentioned above. As a result, it seems that currency hedging is ineffective, as the positive result of the forward exchange contract is lower than the loss in value of a deposit with the same term.

However, there is one other very important factor in the calculation that needs to be considered to see the full picture: the interest that is received on the deposit, which amounts to £2.89 million (\$130.69 million at 3.037% / \$1.3750) offsetting the loss due to the change in the spot exchange rate.

The example in this blog illustrates the fact that hedging currency risk by means of forward exchange contracts can be a very useful tool. However, it is important to include all aspects in any analysis to be able to see the full picture and assess the impact of currency hedging. We’ve shown that it’s easy to forget to include the earned interest in the result, while the interest rate (and thus the interest result) is the main reason for the difference between the forward rate and the spot rate.

This concludes our look at the currency exposure of a deposit hedged by means of a forward exchange contract. However, as most institutional investors run a currency risk because they invest in foreign shares or other investment categories, the third blog in our series will look at how the exposure of a portfolio is calculated and what options there are.