Futures, or a few words about the "future" market - part II

W the first article in this series discussed issues related to, among others, swap pointswhich are an integral part of the futures market. What's more, in the above text you will find information on the basic calculation of the future rate for future transactions and their relationship with the interest rate.

In this article, we'll cover a more complex currency market instrument, which is forward transactions Forward outrights. Perhaps some readers have not yet heard of such an instrument and for the moment it sounds foreign to them. From this text you will learn what it is and learn its structure. The instrument itself works great as one of the options for hedging against currency risk, e.g. caused by the foreign operation of a given enterprise. We invite you to read.

Forward outrights transactions

An important concept in the context of transactions on this type of instrument is the forward rate. It informs us for how much someone is willing to buy or sell the base currency or the currency quoted for a given date. What does the settlement of such a transaction look like? Let's take an example of any USD / PLN exchange rate. Let's assume that the pair's forward price on e.g. April 27.04 is: 4,0455/4,0602. Let's assume that we have USD 1 million, which we want to exchange on April 27.04 for PLN. We conclude such a transaction and we are required to deliver physically currency as at the transaction date.

Further analyzing the example above, we have committed to provide USD 1 million on April 27.04. The bank will buy back a million dollars from us at the exchange rate of 4,0455 in April, thus providing us with PLN 4 045 500. The opposite is true when we want to buy dollars. Then we commit ourselves (after the second exchange rate 4,0602) to deliver PLN 4 060 million to receive USD 200 million, on April 1. Of course, it is not possible to terminate the transaction due to a favorable exchange rate change. If there has been such a big change in our favor, a new forward can be used. The most reasonable solution is to close the transaction, the other forward transaction is only the opposite. We close a purchase on a specific date with sale on the same date and vice versa in the case of sale.

How do forwards affect risk?

Forward transactions are an instrument mainly used to hedge transaction exposure. For the sake of clarification, transaction exposure is associated with the risk of a change in exchange rate, which affects our transaction (decreases its value or increases, which of course reduces the risk). It is widely known that enterprises often conclude purchase or sale contracts with deferred payment, e.g. 30 days. If we look at what has been happening in the currency market recently, taking into account even the USD / PLN pair, the increases and decreases sometimes reached a dozen groszy during the week. Of course, whether the increase or decrease is favorable for us determines which side of the transaction we are on. If we receive a payment in USD, the decline in the national currency (in this case PLN) is favorable for us. This is a typical situation for exporting companies that receive payment for their goods in a foreign currency. The increase in our money in relation to foreign money is beneficial for importers, i.e. in a situation where we are obliged to pay, e.g. in USD.

What do forward transactions protect us from? In short, before currency risk, i.e. a change in the exchange rate between the period of the transaction and the receipt / payment. It is known that shifts are not always bad for us. It's best to illustrate this with an example.

We will take a closer look at the company that imports goods from China, therefore the payment for the ordered products will be in dollars. The company signs a contract for the amount of PLN 300 (current USD / PLN exchange rate of 000), which will amount to USD 4,0422 74 per USD. We undertake to pay this amount to be delivered after 217,01 days (according to the invoice). During this month, the USD / PLN exchange rate increases to 30. The person responsible and authorized to settle accounts will go to the bank and purchase USD 4,1809 at the spot exchange rate (immediate). Currently, he has to pay PLN 74 217,01 for a foreign currency purchased, i.e. PLN 310 293,90 more than 10 days ago. If it had secured the transaction by concluding a forward contract, this loss would have been much smaller, it could be said that it was practically none. Of course, if the USD / PLN exchange rate weakened, the company would take away the opportunity to earn on changing the exchange rate. In that case, we would say that the cost of security will be high.

Summation

The futures market is very complex. The forwards presented in the article are simple instruments the purpose of which is to hedge against currency risk. Of course, they have their advantages and disadvantages, and their choice depends on the preferences of the party making the transaction - in practice, they are most often used by export / import companies.