Back to the future…with Forward Exchange Contracts
Forward exchange contracts (“FECs”), which are usually between a bank and a customer, enable the exchange of one currency into another at a future date and a pre-agreed exchange rate.
Forward exchange contracts (“FECs”) are contracts, usually between a bank and a customer, to exchange one currency into another at a future date and a pre-agreed exchange rate. For example, XYZ bank may agree to sell US$100,000 and buy A$133,300 from its customer, ABC Corp, in 12 months’ time.
Benefits of FECs
FECs are typically used by companies, investors and borrowers wanting to reduce or hedge foreign exchange rate risk.
Banks will typically quote customers forward currency rates, which are similar to spot currency rates (i.e. the exchange rate for settlement within the next two business days), but adjusted to reflect the cost to the bank of borrowing in one currency and lending in another. Forward currency rates can be either higher or lower than spot currency rates depending on interest rates in the respective currencies. Due to the fact that they are influenced by interest rates, forward currency rates are not indicative, or a prediction, of where spot exchange rates may be in the future.
FEC case study
With US one-year interest rates about 1.00% lower than Australian one-year interest rates (i.e. 0.65% per annum in the United States compared with 1.65% per annum in Australia), a 12-month US Dollar to Australian Dollar FEC is currently priced at around US$0.7550, or around 63 basis points below the current spot rate, which is approximately 1.00% lower than the current spot rate (see quote screen below).
With interest rates higher in Australia than in other major currencies such as US Dollars, Yens, Pounds and Euros, it actually pays investors to hedge their foreign currency investments by locking in more favourable forward currency rates compared to current spot currency rates.
Fixed or flexible
FECs come in different forms, some are fixed dated where the currency exchange must take place on an agreed date, whereas other allow for some flexibility in the date on which the currency exchange takes place. FECs with more flexible settlement dates are useful where someone may be receiving some funds in another currency from the sale of an asset, but they are not certain of the exact date that the funds will be received, only that it will be received within a pre-determined time frame e.g. between four months and six months’ time.
FECs can be terminated or “closed out” prior to maturity, effectively by entering into an opposing FEC with the same bank. For example, a customer initially takes out a 12-month FEC to buy Australian Dollars and sell US Dollars and then six months later decides to close out the transaction, which effectively involves entering into a six-month FEC to buy US Dollars and sell Australian Dollars. Any gain or loss on the original FEC would usually be paid in Australian Dollars at the time of close out.
Fund managers that hedge their foreign investments often use rolling FECs to try to hedge their foreign investments which may fluctuate in value. For example, they may use rolling one-month FECs. At the end of the month when the FEC is due to expire, they pay or receive the gain or loss on the FEC to or from the bank (depending on where the spot exchange rate is relative to the original forward exchange rate) and then enter into a new one-month FEC for an amount that may take into account any change in the value of the foreign investments.
As banks are entering into legally-binding contracts for the exchange of funds in the future, bank customers wanting to enter into FECs must undergo a credit assessment by the bank, or provide collateral to the bank, to ensure that they have the financial capacity to settle the FECs on the due date.