3. Outright forwards International Financial Services 1 Karel Bruna

Main Business Problems (outright forwards) Company and FX exposure based on simple transaction (static example) Outright forward as the main instrument how to lower FX exposure Pricing mechanism of outright forwards Pros and cons of outright forwards

Main Characteristics of Outright Forwards Maturity: 1M, 2M, 3M, 6M, 9M, 12M + odd dates Price: bid/ask forward rate (FR) Currency pairs: as in case of spot contracts Amount: minimum defined by the market maker Interest Rates: interbank deposit/lending rates yields of treasury instruments Time conventions: act/360 or act/365

Forward Rate Quotation

Forward Rate Calculation and Quotation ( outright quotation) 1 + IR USD,D (t/360) FR BID (USD/EUR) = SR BID (USD/EUR) IR EUR,L (t/360) 1 + IR USD,L (t/360) FR ASK (USD/EUR) = SR ASK (USD/EUR) IR EUR,D (t/360)

Forward Rate Calculation and Quotation Example of high points/low points quotation spot rate quotation: BID ASK SR (USD/EUR) 1,2393 1,2396 money market quotation: D L 1M IR EUR (% p.a.) 2,03 2,05 1M IR USD (% p.a.) 1,08 1,11 outright forward rate calculation: 1 + IR USD,D (t/360) 1 + 0,0108(30/360) FR BID = SR BID = 1, = 1,2383USD/EUR 1 + IR EUR,L (t/360) 1 + 0,0205(30/360) 1 + IR USD,L (t/360) 1 + 0,0111(30/360) FR ASK = SR ASK = 1, = 1,2387USD/EUR 1 + IR EUR,D (t/360) 1 + 0,0203(30/360)

Forward Rate Calculation and Quotation ( quotation in forward or swap points) BID points: (FR BID - SR BID ) (FR BID - SR BID ) ASK points: (FR ASK - SR ASK ) (FR ASK - SR ASK )

Forward Rate Calculation and Quotation Example of high points/low points quotation forward (swap) points calculation: (FR BID - SR BID ) = (1, ,2393) = - 10 points (FR ASK - SR ASK ) = (1, ,2396) = - 9 points outright forward quotation: BID ASK FR (USD/EUR) 1,2383 1,2387 forward (swap) points quotation: USD/EUR 10/9 spot exchange rate spread: (SR ASK - SR BID ) = (1, ,2393) = 3 points forward rate spread: (FR ASK - FR BID ) = (1, ,2383) = 4 points

Forward Rate Calculation and Quotation FR > SR  base currency is at premium and quoted currency is at discount  quoted as low points/high points FR BID = SR BID + low points FR ASK = SR ASK + high points FR < SR  base currency is at discount and quoted currency is at premium  quoted as high points/low points FR BID = SR BID - high points FR ASK = SR ASK - low points

Pricing Mechanism of Outright Forwards forward rate of standard forward contract implied forward rate of synthetic forward contract

Pros and cons of outright forwards Arguments for outright forwards: Main instrument for FX exposure management Easy and cheap way how to obtain fixed exchange rate Possibility how to lower volatility of cash-flow Arguments against outright forwards: Suitable only for transactions with known amount and maturity Suitable only for static examples of FX exposure