We recently talked to a pension fund about hedging currency risk using currency derivatives, such as forward exchange contracts or currency swaps. They were of the opinion that currency hedging was inefficient to implement and that the share premium, or the forward points, for a GBP/USD forward exchange contract were relatively high. In today’s environment, a lot can happen in twelve months, making hedging a necessity to manage foreign currency exposure.
28 Jan 2019
Over the course of the next 8 weeks, we will publish a series of blogs on the importance of hedging foreign currency exposure. In this first blog, we’ll begin by explaining the influencing factors on the forward rate. In future blogs, we will discuss these points and their impact on the return. We’ll also make the step from theory to practice and compare the theoretic forward rate with the actual forward rate as it is priced in the market, hopefully giving you enough context and information to determine the effectiveness of a robust hedging approach to reduce currency risk.
1. What is a forward exchange contract?
First of all, let’s start from the beginning: a forward or a forward contract is a foreign exchange transaction, which has settlement after the spot date. The spot rate: this is the currency exchange rate at which a currency pair can be bought or sold (e.g. selling GBP for USD). The spot forex rate differs from the forward rate in that it prices the value of currencies today, rather than at some point in the future.
2. Does a forward exchange contract trade come at a price?
It’s important to begin with the theory behind a forward rate:
A forward exchange contract is almost the same as trading a currency pair (e.g. selling GBP for USD) in the spot market. The price paid is the exchange rate for trading a specific currency pair. However, there is a major difference between trading on ‘the spot market’ and trading under ‘a forward exchange contract’. Trading currencies in the long term rather than on the spot date comes at a price. This price is expressed in forward points.
3. What causes the difference between the spot rate and the forward rate?
Although other factors are at play, interest rates are the main driver in the gap between the spot rate and the forward rate. This is reflected by the interest rate difference between the currency pair. The reason that the forward rate differs from the spot rate is down to the interest earned on the currency being entered into the exchange during the term of the forward contract. Technically, if there is no interest rate difference, then the spot rate would be equal to the forward rate.
4. How is the forward rate calculated?
Here is an example of the choice an investor - let’s call her Rebecca - can make when lending her money:
Choice 1: Investment via a 12-month deposit in the same currency
Rebecca lends out GBP 100,000,000 under a 12-month deposit at the prevailing interest rate of 1.158% (12-month Libor as at 23 January 2019). At the end of the period, the capital has increased to GBP 101,158,000, as a result of the interest rate.
Choice 2: Investment via a 12-month deposit in a currency with a higher interest rate
This time, Rebecca lends out her money in USD by means of a deposit by exchanging her Pound Sterling at a rate of 1.3069(as at 23 January 2019) for Dollars resulting in USD 130,690,000. The interest rate in the USA is considerably higher at 3.037% (12-month US-Libor as at 23 January 2019), so the deposit results in the capital position increasing to USD 134,659,055.30.
The forward rate on the 12-month forward rate of the dollar is 1.3389 (GBP/USD currency pair), meaning that the return in Pound Sterling is still GBP 100,574,393.38.
5. So why hedge out your currency liability?
As illustrated by the examples above, the difference in interest rates is factored into the forward rate calculations, making it theoretically impossible for Rebecca to have a more profitable outcome if she takes Choice 2 rather than Choice 1.
So why are forward exchange contracts so popular? Is there something that we have overlooked in our examples above?
The answer is simple – a lot can change in 12 months! By entering into a foreign exchange contract, you are locking in the rate agreed at the time of the contract initiation, meaning that you have control over your exposure during that period, regardless of any market changes that may occur during that time.
We hope you have enjoyed the first of our blog series on currency hedging. In the next article we’ll go into more detail about the differences between theory and practice.