Forward transactions

Forward Exchange Contracts

A Forward Exchange Contract is a contract between St.George Bank Ltd and you where the Bank agrees to BUY from you, or SELL to you, foreign currency on a fixed future date, at a fixed rate of exchange. You undertake to pay the Bank, the overseas currency in terms of the contract in exchange for the settlement currency, which would usually be Australian Dollars. The Bank can provide a Forward Exchange Contract in most overseas currencies, for the protection of Exporters and Importers who are subject to exchange risks in the course of their international transactions.

What are Forward Exchange Contracts?

A Forward Exchange Contract is an agreement between you and the Bank, in which the Bank agrees to Buy or Sell foreign currency to you on a fixed future date, or during a period expiring on a fixed future date, at a fixed rate of exchange. You undertake to pay the Bank, or receive from the Bank, the overseas currency in terms of the contract in exchange for the settlement currency, usually Australian Dollars. The Bank can provide a Forward Exchange Contract in most overseas currencies, for the protection of Exporters and Importers who are subject to exchange risks in the course of their international transactions. Forward Exchange Contracts can be used to cover your exchange risk between an overseas currency and Australian dollars or between two overseas currencies. The contract may be entered into at anytime and can be used to cover both trade and non-trade transactions. As with the Exchange Rate, Forward Exchange Contracts are described as Buying or Selling Contracts. For an Importer, the Bank contracts to sell overseas currency, hence a Bank Selling Contract is established for a future date. At maturity, the Bank Selling Contract is used to meet the Importer's overseas commitment. In the case of an Exporter the contract is a Buying Contract. An Australian Importer may place an order overseas for goods with payment to be made to the supplier in overseas currency. The Importer knows the Selling Exchange rate for the currency concerned when he places an order, and can calculate the costs of the goods in Australian currency at that time.

However, a payment to the overseas supplier is seldom made at the time of placing the order. The Exchange Rate may alter before the Importer is due to make payment or the actual cost of the goods may vary significantly. Therefore the Importer has an exchange risk. The establishment of a Forward Exchange Contract will enable the Importer to protect against adverse movements in the exchange rate, but cannot provide a 'perfect' hedge should the actual cost of the goods vary.

Types of Forward Exchange Contracts

Forward Exchange Contracts, both Buying and Selling, may be either fixed or optional term contracts.

Fixed Term Contracts

With a Fixed Term Contract the customer specifies the date on which delivery of the overseas currency is to take place. An earlier delivery can be arranged but it may involve a marginal adjustment to the Forward Contract Rate.

Optional Term Contracts

Optional Term Contracts can be entered into for a specific period, and the customer states the period within which delivery is to be made (normally for periods not more than one month) eg. a contract may be entered into for a six month period with the customer having the option of delivery at anytime during the last week. In each case there is a firm contract to effect delivery by both the Bank and the customer. An optional delivery contract does not give the customer an option to not deliver the Forward Exchange Contract. It is only the period during which delivery may occur that is optional. Forward rates are quoted for transactions where settlement is to take place more than two business days after the transaction date. Forward Contract rates consist of the Spot rate for the currency concerned adjusted by the relative Forward Margin. Forward Margins are a reflection of the interest rate differentials between currencies, and not necessarily a forecast of what the spot rate will be at the future date. Therefore it is essential for the Financial Controller to be aware of the interest rates prevailing in the countries with which their Company is doing business. The Forward rate may be expressed as being at parity (par), or at a Premium (dearer) or at a Discount (cheaper), when related to the spot rate. It follows therefore that premiums are deducted from the spot rate and discounts are added to the spot rate. Forward Rates incorporating a 'Premium' are more favourable to exporters and less favourable to importers than the relative spot rates on which they are based. Similarly, Forward rates incorporating a 'Discount' are more favourable to importers and less favourable to exporters that the relative spot rates on which they are based. The general rule in determining whether a currency will be quoted at a premium or a discount is as follows: The currency with the higher interest rate will be at a discount on a forward basis against the currency with the lower interest rate. The currency with the lower interest rate will be at a premium on a forward basis against the currency with the high interest rate. As the interest differential between the currencies widens then the premium or discount margin increases (i.e. moves farther from parity) and similarly as the interest differential narrows then the premium or discount margin decreases (ie moves towards parity).

Importers
The importer buys the foreign currency at spot (i.e. forgoes use of AUD) and invests the foreign currency until required. On due date of the payment, the foreign currency deposit matures, plus interest earned, and the payment to the overseas supplier is made. Consideration must be given to the taxation and cash flow implications of hedging your exchange risk in this manner.

Exporters
The exporter could borrow the foreign currency (representing proceeds to be received at a future date), and sell the borrowed foreign currency to the Bank at spot, for which AUD is received. The proceeds from the export sale are later used to repay foreign currency borrowing.

Example
Australian Importer has a commitment to pay USD for goods in six months time. Exchange Risk AUD/USD Calculation of Forward Rate Spot Selling Rate .5100 Less Margin - .0033 Forward Rate .5067 Interest Rate Calculation of Margin Borrow AUD at cost of 6% Place USD on Deposit at 3.0% Deposit matures, net interest cost 3.0% *Interest Difference is expressed as a number (eg 1.3% = .0033) for the period of the contract. In effect, the forward rate represents the 'price' of covering a forward exchange risk. The 'cost' of covering an exchange risk is not simply the discount or premium by which the spot rate is adjusted at the time the forward contract is entered into, but rather it is the difference between the contract rate and the spot rate at the time delivery is affected. In other words if the decision had been taken not to cover forward then the transaction would have been handled at the future spot rate.

A forward contract is much like a futures contract in that it is an agreement for the future delivery of some amount of something at a specified price and at a specified time in the future. Sounds exactly the same in fact; but there are a number of important differences

Standardisation The first important distinction is that futures contracts are standardised agreements traded on exchanges, whereas forward contracts are non-standardised contracts negotiated directly between the buyer and the seller. They are, essentially, OTC futures. Standardisation in terms of amounts, prices, delivery dates and so on is important because it creates liquidity. The downside of standardisation is that buyers and sellers do not have the flexibility to negotiate contracts which reflect exactly the positions they want to take. Settlement Another important difference is that, although both futures and forward contracts establish terms of delivery how much, at what price and when futures contracts are not generally intended to be settled by delivery. In fact, generally less than 2% of futures contracts are delivered or go to final settlement. However, forward contracts are intended to be held to final settlement even if they settle in cash rather than delivery of the underlying. Risk Finally, both parties in a forward contract are exposed to credit risk because there is a possibility that either party may default. This risk is almost zero with futures contracts because the buyer and seller are not dealing directly with each other but with the exchange which trades the contract and which through what is called its clearing house guarantees both sides of the transaction.

Foreign exchange spot

A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate. As of 2010, the average daily turnover of global FX spot transactions reached nearly 1.5 trillion USD, counting 37.4% of all foreign exchange transactions

Settlement date
The standard settlement timeframe for foreign exchange spot transactions is T + 2 days; i.e., two business days from the trade date. A notable exception is theUSD/CAD currency pair, which settles at T + 1. [edit]Execution

methods

Common methods of executing a spot foreign exchange transaction include the following:[1]

Direct. Executed between two parties directly and not intermediated by a third party. For example, a transaction executed via direct telephone communication or direct electronic dealing systems such as Reuters Conversational Dealing.

Electronic broking systems. Executed via automated order matching system for foreign exchange dealers. Examples of such systems are EBS and Reuters Matching 2000/2.

Electronic trading systems. Executed via a single-bank proprietary platform or a multibank dealing system. These systems are generally geared towards customers. Examples of multibank systems include FXall, Currenex, FXConnect, Globalink and eSpeed.

Voice broker. Executed via telephone communication with a foreign exchange voice broker.

Forward contract

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to theforward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.
[2]

Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like

futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000. The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not

wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract. In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current ratethese two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts. [edit]Example

of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him the opportunity cost will be covered. [edit]Spotforward

parity

Main article: Forward price See also: Cost of carry and convenience yield For liquid assets ("tradeables"), spotforward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset: pays income, and if so whether this is on a discrete or continuous basis incurs storage costs is regarded as

an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold, financial securities);

or a consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron ore etc.

Clearing and Settlement System

OSE-FX Settlement System
OSE-FX settlement is through resale or repurchase during the trading session on a trading day.

Clearing and Settlement

FX cash differences resulting from daily trading and rollover are paid/ received through increasing/ decreasing margins.

Margins are increased/ decreased 2 days later (T+2) that is a bank business day in Japan. Settlement day

FX Cash Differences
The FX cash difference is the sum total of 1 - 4 below: FX settlement price

FX settlement price is determined by OSE based on VWAP during the last 5 minutes before the market closes, in principle. Rollover Open positions that are not resold or repurchased by the end of the trading session on a trading day expire at the end of the trading day and the same positions (excluding expiration of the contracts) are opened for the next trading day at the same time.

Base currency Profit and loss of Yen-denominated currency contracts is calculated by Japanese yen (JPY). Profit and loss of non-yen-denominate currency contracts is calculated by USA dollar (USD). However, clearing and settlement of non-yen-denominate currency contracts is used by exchange rate against JPY. 1. Cash difference between executed price and FX settlement price 2. Mark-to-market value, i.e. cash difference between the FX settlement price of the previous day and the FX settlement price of the day 3. FX cash difference in case of closing trade 4. Swap points (SP), i.e. equivalent to interest-rate differential * SP is received if a long position is held for a higher-interest currency or a short position is held for a lowerinterest currency when comparing the interest rates of the currency pair. In case of USD/JPY trading (interest rate of USD > interest rate of JPY), SP is received if a long position is held. * SP for non-yen-denominated currency contracts is determined with yen equivalent. * FX cash difference for non-yen-denominated currency contracts is yen equivalent calculated by multiplying the sum total of the above cash differences by exchange rate against JPY.