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CPA Forward Exchange Contracts - YouTube
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[Music]
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foreign exchange contracts or feces lock
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in a foreign exchange rate for
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settlement at a future date the
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locked-in fx rate is referred to as the
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forward fx rate this rate is not a
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forecast but is a calculated rate based
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on the current spot rate and the
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interest rate differential between the
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times currency and the base currency the
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formula for calculating the forward rate
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is as follows with spot being the spot
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exchange rate i t is the interest rate
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of the times currency ib is the interest
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rate of the base currency d is the days
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in the period and why is the day count
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convention
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the foreign therefore reflects the
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future value of the sport rate and
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similarly the sport rate reflects the
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present value of the forward rate
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ford exchange contracts are used when an
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organization has a non-payment or
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receipt taking place in the future
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they commit the organization to buy or
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sell the best currency at the forward
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rate at settlement this locks in the
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organization's cash flows eliminates
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volatility and can ensure a satisfactory
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financial outcome
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however because it locks in the outright
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rate the downside is that the
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organization will not benefit from
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favorable movements in the exchange rate
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between now and the forward settlement
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date
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let's now look at an example
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an australian importer has 1 million new
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zealand dollars commitment in 12 months
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time the spot rate is currently
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australian to new zealand dollars of 1.1
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equating to a current cost of 909 091
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australian dollars which is calculated
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as a million new zealand dollars divided
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by 1.1
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fluctuations in the exchange rate over
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the next 12 months will change the
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australian dollar cost for the importer
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as follows if the exchange rate is one
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the cost will be 1 million australian
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dollars if it is 1.05 it will be 952
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381 australian dollars and so on not how
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the payment amount decreases as the
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exchange rate rises to lock in an
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australian dollar amount the importer
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could enter into an fec with a bank to
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sell australian dollars and buy a
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million new zealand dollars at the
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current 12-month forward rate assuming
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interest rates in new zealand were four
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percent and interest rates in australia
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the base currency were two percent the
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forward rate is calculated using the
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formula as follows
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1.1 is the spot rate the interest rate
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of the times currency is 0.04 the
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numerator of 365 represents the days in
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the period which in this case is a year
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the denominator is the day count
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convention in new zealand which is 365.
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the interest rate of the base currency
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is 0.02
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the day count convention in australia is
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also 365.
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based on the formula the forecast rate
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is therefore calculated as 1.1216
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regardless of the exchange rate
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fluctuations over the next 12 months the
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australian importer has locked in the
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aud cost for the purchase of 891 583
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calculated as a million new zealand
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dollars divided by 1.1216
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while this locks in an australian dollar
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amount and protects the downside from a
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falling australian dollar it also means
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that the importer cannot benefit from
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the rising australian dollar
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as can be noted from the last column in
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the table the company will be able to
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protect itself against rates that are
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lower than 1.1216
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but will not benefit if rates rise above
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1.1216
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let us finally consider an example
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relating to an exporter
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an australian exporter expects to
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receive 2 million us dollars in three
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months time the spot rate is currently
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australian dollars to us dollars 0.6
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equating to a current receipt of 3
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million
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three thousand three hundred and thirty
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three australian dollars calculated as
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two million us dollars divided by zero
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point six
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fluctuations in the exchange rate over
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the next three months will change the
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australian dollar receipt for the
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exporter as an example
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if the exchange rate is 0.5 then the
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receipt will be 4 million australian
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dollars if it is 0.55 the receipts will
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be 3 million 636
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364 australian dollars and so on
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not how the receipt amount decreases as
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the exchange rate rises to lock in an
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australian dollar amount the exporter
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could enter into an fec with a bank to
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buy australian dollars and sell two
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million us dollars at the current
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three-month forward rate
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assuming interest rates in the u.s were
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one percent and interest rates in
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australia were two percent
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then the forward rate is calculated as
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follows 0.6 is export rate the interest
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rate of the times currency is 0.01 the
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numerator of 365 represents the days in
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the period which in this case is a year
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the denominator is the day count
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convention in the u.s which is 360.
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the interest rate of the best currency
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is 0.02
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the day count convention in australia is
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365.
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this results in a forward rate of 0.5985
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regardless of the exchange rate
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fluctuations over the next three months
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the australian exporter has locked in
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the receipts for the sale of three
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million three hundred and forty one
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thousand six hundred and eighty eight
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australian dollars calculated by
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dividing two million us dollars by
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0.5985
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while this locks in an australian dollar
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amount and protects the downside from a
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rising australian dollar it also means
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that the importer cannot benefit from a
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falling australian dollar as can be
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noted from the last column the company
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will be able to protect itself against
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rates that are higher than 0.5985
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but will not benefit if rates decrease
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below the forward rate
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to recap
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forwards locking an amount rate and a
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future settlement date the fec therefore
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effectively eliminates the exposure both
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favorable and unfavorable to future
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exchange rate movements
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it is also important to remember that
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forward rates are calculated rates not
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forecast rates they are based on the
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current support rate as well as the
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interest rate differential between the
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two currencies
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