Forward Markets, FX Swap Markets, and Currency Options

Suppose that a South Korean phone manufacturer wants to contract with a Chinese company to manufacture its phones and tablets. If the Chinese company demands payment in CNY instead of KRW, what is the phone manufacturer's risk if the payment is due in 90 days?

No. The USD isn't involved in the transaction.

No. That's going to make the manufacturing process cheaper, so it's a good thing.

That's right! If CNY appreciates versus KRW, the manufacturing cost due in 90 days will be more expensive, which is a risk to the phone manufacturer. That's why the manufacturer should consider using a forward contract, which is an agreement to exchange one currency for another on a future date at an exchange rate agreed on today. So that means that forward contract settles beyond the spot market of two business days. But even though the settlement is different, the spot exchange rate still plays an important role in the forward contract market because the forward contract sets the future exchange rate today. So the spot rate is the starting point of the transaction.

For example, with the phone manufacturer's 90-day due date on its payable, the company will want to use a three-month forward contract to hedge. That contract is quoted in points. Points are the difference between the forward exchange rate quote and the spot exchange rate quote, and they are scaled so that they can relate to the last decimal in the spot quote. Basically, that means that a forward contract is quoted in positive or negative decimals for both the bid and offer price. So if the forward contract quote is negative versus the spot exchange rate, how would you describe that forward contract?

That's it! Since the forward points are negative, that means that the forward contract trades at a discount to the spot price. So the forward contract rate is less than the spot exchange rate. But you'll need to be careful in the application of the forward contract points and which side of the quote you use. For example, to use forward points, you need to scale the quote by 10,000 to bring it to the fourth decimal place of the spot exchange quote. So, the scaling is simply $$\displaystyle \displaystyle\frac{\mbox{Forward contract points}}{10{,}000}$$.

Not quite. That would mean that the forward rate is greater than the spot exchange rate.

No. The forward contract trades below the spot exchange rate.

Then, you'll need to add or subtract the forward points to the right side of the spot quote. In the phone manufacturer's case, the company needs to essentially buy CNY forward, so which point of the spot quote is used to calculate the forward exchange quote?

No, actually. That's the price at which the counterparty will buy the currency.

Yes. The offer price is the one that the phone manufacturer will have to pay to buy CNY. So you would adjust the offer price by the forward points adjusted by 10,000, and that's the forward exchange rate where the phone manufacturer could buy CNY to fulfill its manufacturing order. It's called the all-in forward rate. Then, in 90 days the CNY amount will change hands. But even though the exchange of funds occurs in 90 days, the phone manufacturer may want to understand the market value of the forward contract. This will allow the company the ability to understand the effectiveness of the hedge and measure the profitability of the trade.

No. The phone manufacturer wants the trade filled, so it'll meet the market maker on one side of the quote.

In order to find the market value or mark the contract to market, you'll need to find the value of the contract that would close out the open forward market contract. That value depends on changes in the spot rate and the changes in interest rates in either currency. For example, suppose that after two months the phone manufacturer wants to close out its three-month forward contract. What forward contract value will the company need to start with to calculate the mark-to-market value?

Exactly! After two months, the phone manufacturer will close its three-month forward contract with a one-month contract to sell CNY. Remember that the phone manufacturer needed to purchase CNY to pay the manufacturing order, and now it wants to close that forward contract, so CNY needs to be sold. That means that the bid side of the current spot rate will need to be used to calculate the all-in forward rate.

Not quite. The phone manufacturer has already held its three-month forward contract for two months, so that's not going to close the position.

No, actually. That's the original contract that the phone company initiated.

From there, you can calculate the gain or loss from the company's original three-month forward rate versus the current all-in forward rate that will close out the position, multiplied by the notional value of the contract. So the cash flow at settlement is the following. $$\displaystyle (\mbox{Three-month all-in forward rate - One-month all-in forward rate}) \times \mbox{Notional Value}$$ The cash flow at settlement will be paid in one month and is a net transaction to the party that had a gain on the trade. Suppose that CNY appreciated while the phone manufacturer held the three-month forward contract. How would you describe the phone manufacturer's cash flow?

Yes indeed! The phone manufacturer will receive money from the forward contract because CNY appreciated while it held the contract that was long CNY. Remember the company needed to buy CNY, so the forward contract put the company in a long CNY position. For the final step in the mark-to-market process, you need to calculate the present value of that one-month future contract inflow by the corresponding time period discount rate. So you'll use the one-month CNY discount rate to calculate the present value that the company will receive.

No. CNY appreciated while the phone manufacturer held the three-month contract.

That's not it. Since CNY appreciated, there's going to be a gain or loss.

To summarize: [[summary]]

CNY depreciates versus USD

KRW appreciates versus CNY

CNY appreciates versus KRW

Trades at a discount

Trades at a premium

Trades in equilibrium

Bid

Offer

Median of the spread

One month

Two months

Three months

There's an inflow

There's an outflow

There's no gain or loss

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