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Trading and Capital-Markets Activities Manual

Instrument Profiles: Forwards
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

GENERAL DESCRIPTION 

Forwards are financial contracts in which two counterparties agree to exchange a specified amount of a designated product for a specified price on a specified future date or dates. Banks are active participants in the forward market. Forwards differ from futures (discussed separately in this manual) in that their terms are not standardized and they are not traded on organized exchanges. Because they are individually negotiated between counterparties, forwards can be customized to meet the specific needs of the contracting parties. 

CHARACTERISTICS AND FEATURES 

Forwards are over-the-counter (OTC) contracts in which a buyer agrees to purchase from a seller a specified product at a specified price for delivery at a specified future time. While forward contracts can be arranged for almost any product, they are most commonly used with currencies, securities, commodities, and short term debt instruments. (Forwards on short-term debt instruments, or ''forward rate agreements,'' are discussed separately in this manual.) Commitments to purchase a product are called long positions, and commitments to sell a product are called short positions. 

Foreign-exchange forward contracts constitute the largest portion of the forward market. They are available daily in the major currencies in 30-, 90-, and 180-day maturities, as well as other maturities depending on customer needs. Contract terms specify a forward exchange rate, a term, an amount, the ''value date'' (the day the forward contract expires), and locations for payment and delivery. The date on which the currency is actually exchanged, the ''settlement date,'' is generally two days after the value date of the contract. 

In most instances, foreign-exchange forwards settle at maturity with cash payments by each counterparty. Payments between financial institutions arising from contracts that mature on the same day are often settled with one net payment. 

USES 

Market participants use forwards to (1) hedge market risks, (2) arbitrage price discrepancies within and between markets, (3) take positions on future market movements, and (4) profit by acting as market makers. Financial institutions, money managers, corporations, and traders use these instruments for managing interest-rate, currency, commodity, and equity risks. While most large financial institutions are active in the interest-rate and foreign-exchange markets, only a handful of financial institutions have exposures in commodities or equities. 

Hedging Interest-Rate Exposure 

Financial institutions use forwards to manage the risk of their assets and liabilities, as well as off-balance-sheet exposures. Asset-liability management may involve the use of financial forwards to lock in spreads between borrowing and lending rates. For example, a financial institution may sell an interest-rate forward contract in advance of an anticipated funding to lock in the cost of funds. If LIBOR subsequently increases, the short position will increase in value, offsetting the higher spot interest cost that the financial institution will have to pay on its funding. 

Forward contracts may be used to hedge investment portfolios against yield curve shifts. Financial institutions can hedge mortgage portfolios by selling GNMA forwards, and government bond dealers may sell forwards to hedge their inventory. Pension and other types of benefits managers may hedge a fixed future liability by selling forwards or may hedge an expected receipt by buying forwards. When offsetting swaps with the necessary terms cannot be found, interest-rate swap dealers may also use forwards, as well as Eurodollar futures and Treasury futures, to hedge their unmatched commitments. 

Hedging Foreign-Exchange Exposure 

Corporations engaged in international trade may use foreign-currency contracts to hedge payments and receipts denominated in foreign currencies. For example, a U.S. corporation that exports to Germany and expects payment in deutschemarks (DM) could sell DM forwards to eliminate the risk of a depreciation of the DM at the time that the payment arrives. A corporation may also use foreign-exchange contracts to hedge the translation of its foreign earnings for presentation in its financial statements. 

Financial institutions use foreign-exchange forwards to hedge positions arising from their foreign-exchange dealing businesses. An institution that incurs foreign-exchange exposure from assisting its customers with currency risk management can use offsetting contracts to reduce its own exposure. A financial institution can also use forwards to cover unmatched currency swaps. For example, a dealer obligated to make a series of DM payments could buy a series of DM forwards to reduce its exposure to changes in the DM/$ exchange rate. 

Arbitrage 

Risk-free arbitrage opportunities in which a trader can exploit mis-pricing across related markets to lock in a profit are rare. However, for brief periods of time, pricing in the forward market may not be consistent with pricing in the cash market. For example, if DM forwards are overpriced relative to the rates implied by interest-rate parity relationships, a trader could borrow dollars, sell them against spot DM, purchase a DM deposit, and sell the DM forward. This arrangement would lock in a risk-free return. 

DESCRIPTION OF MARKETPLACE 

Primary Market 

Forward contracts are not standardized. Market makers such as banks, investment banks, and some insurance companies arrange forward contracts in various amounts, including odd lots, to suit the needs of a particular counterparty. Brokers, who arrange forward contracts between two counterparties for a fee, are also active in the forward market. End-users, including banks, corporations, money managers, and sovereign institutions, use forwards for hedging and speculative purposes. 

Secondary Market 

Once opened, forwards tend not to trade because of their lack of standardization, the presence of counterparty credit risk, and their limited transferability. 

Market Transparency 

The depth of the interest-rate and foreign exchange markets and the interest-rate parity relationships help ensure transparency of forward prices. Market makers quote bid/ask spreads, and brokers bring together buyers and sellers, who may be either dealers or end-users. Brokers distribute price information over the phone and via electronic information systems. 

PRICING 

In general, the value of a long forward contract position equals the spot price minus the contract price. For example, forward (and spot) foreign exchange rates are quoted in the number of units of the foreign currency per unit of the domestic currency. Forward foreign-exchange rates depend on interest-rate parity among currencies. Interest-rate parity requires the forward rate to be that rate which makes a domestic investor indifferent to investing in the home currency versus buying foreign currency at the spot rate, investing it in a foreign time deposit, and subsequently converting it back to domestic currency at the forward rate. The interest-rate parity relationship can be expressed as- 

              F = S [1 + r(F)] / [1 + r(D)], 

where F is the forward rate, S is the spot rate, r(D) is the domestic interest rate, and r(F) is the foreign interest rate. Currency rates are foreign currency per unit of domestic currency. For example, assume the 180-day dollar ($) interest rate is 5 percent, the 180-day DM interest rate is 10 percent, and the DM/$ spot rate is 1.3514 (DM per dollar). A dollar-based investor can borrow dollars at 5 percent, sell them against DM at the DM/$ spot rate of 1.3514, and invest the DM at a 10 percent rate of return. When the investment matures, the DM proceeds can be reconverted to dollars at the forward rate of 1.4156 DM for each dollar, giving the investor a total dollar return of 5 percent, which is the same return available in dollar deposits. In this instance, the forward rate is higher than the spot rate to compensate for the difference between DM- and dollar-based interest rates. The difference between the domestic and foreign interest rates is referred to as the ''cost of carry.'' 

HEDGING 

Positions in forwards can be offset by cash-market positions as well as other forward or futures position. A financial institution's exposure from a foreign-exchange forward contract can be split into a spot-currency component and an interest-rate differential between the two currencies. For the spot foreign-exchange component, consider a three-month long forward position that receives sterling () and pays dollars (in three months, the institution receives sterling and pays dollars). This position is comparable to the combination of receiving a three-month dollar deposit and making a three-month sterling loan. The forward position implicitly locks in a spread between the lending and borrowing rates while exposing the institution to future /$ spot rates. 

To eliminate the currency and interest-rate exposure, the financial institution can either enter into an offsetting forward or take a short position in sterling. By entering into a three-month forward contract to deliver sterling against dollars, the financial institution could virtually eliminate its currency exposure. Alternatively, the institution could borrow three-month sterling, sell it, and invest the dollar proceeds in a three-month deposit. When the long /$ forward comes due, the institution can use the maEagle Tradersg dollar deposit to make its payment and apply the sterling proceeds to the repayment of the sterling loan. 

RISKS 

Users and providers of forwards face various risks, which must be well understood and carefully managed. The risk-management methods applied to forwards and futures may be similar to those used for other derivative products. 

Credit Risk 

Generally, a party to a forward contract faces credit risk to the degree that its side of the contract has positive market value. In other words, credit risk in forwards arises from the possibility that a contract has positive replacement cost and the counterparty to the contract fails to perform its obligations. The value of a contract is generally zero at inception, but it changes as the market price of the product underlying the forward changes. If the institution holds a contract that has positive market value (positive replacement cost) that the counterparty defaults on, the institution would forfeit this value. To counter this risk, weak counterparties may be required to collateralize their commitments. Counterparties dealing with financial institutions may be required to maintain compensating balances or collateral. Because of their credit risk and the lack of standardization, forwards generally cannot be terminated or transferred without the consent of each party. 

As part of their risk management, financial institutions generally establish credit lines for each trading counterparty. For foreign exchange (spot and forward), the lines are most often expressed in notional terms. These credit lines include global counterparty limits, daily counterparty settlement limits, and maturity limits. Some sophisticated financial institutions use credit-equivalent risk limits rather than notional amounts for their foreign-exchange exposure. For interest-rate risk, financial institutions usually express their exposure in credit equivalents of notional exposure. Financial institutions may require a less creditworthy counterparty to pledge collateral and supplement it if the position moves against the counterparty. 

Market Risk 

The risk of forward contracts should be evaluated by their effect on the market risk of the overall portfolio. Institutions that leave positions in the portfolio un-hedged may be more exposed to market risk than institutions that ''run a matched book.'' A financial institution may choose to leave a portion of its exposure uncovered to benefit from expected price changes in the market. However, if the market moves against the institution's prediction, the institution would incur losses. 

Basis Risk 

Basis risk is the potential for loss from changes in the price or yield differential between instruments in two markets. Although risk from changes in the basis tends to be less than that arising from absolute price movements, it can sometimes represent a substantial source of risk. Investors may set up hedges, which leave them vulnerable to changes in basis between the hedge and the hedged instrument. 

Yield-curve risk may also arise by holding long and short positions with equal durations but different maturities. Although such arrangements may protect against a parallel yield-curve shift, they may leave investors exposed to the risk of a nonparallel shift causing uneven price changes. In foreign currency, basis risk arises from changes in the differential between interest rates of two currencies. 

Liquidity Risk 

Forwards are usually not transferable without the consent of the counterparty and may be harder to liquidate than futures. To eliminate the exposure of a contract, a customer may have to buy an offsetting position if the initial dealer does not want to unwind or allow the transfer of the contract. 

Clearing and Settlement Risk 

In OTC markets, clearing and settlement occur on a bilateral basis thereby exposing counterparties to intraday and overnight credit risks. To reduce these risks as well as transactions costs, many financial institutions have bilateral netting arrangements with their major counterparties. Position netting allows counterparties to net their payments on a given day, but does not discharge their original legal obligations for the gross amounts. Netting by novation replaces obligations under individual contracts with a single new obligation. 

ACCOUNTING TREATMENT 

The accounting treatment for foreign-exchange forward contracts is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 133, ''Accounting for Derivatives and Hedging Activities.'' (See section 2120.1, ''Accounting,'' for further discussion.) 

RISK-BASED CAPITAL WEIGHTING 

The credit-equivalent amount of a forward contract is calculated by summing- 

 1. the mark-to-market value (positive values only) of the contract and 
 2. an estimate of the potential future credit exposure over the remaining life of each contract. 

The conversion factors are below. 

                                               Credit-Conversion
Remaining Maturity                   Factor 
One year or less                        0.00% 
Five years or less                      0.50% 
Greater than five years               1.50% 

If a bank has multiple contracts with a counterparty and a qualifying bilateral contract with the counterparty, the bank may establish its current and potential credit exposures as net credit exposures. (See section 2110.1, ''Capital Adequacy.'') For institutions that apply market-risk capital standards, all foreign-exchange transactions are included in value-at-risk (VAR) calculations for market risk. 

LEGAL LIMITATIONS FOR BANK INVESTMENTS 

Forwards are not considered investments under 12 USC 24 (seventh). The use of these instruments is considered to be an activity incidental to banking, within safe and sound banking practices. 

REFERENCES 

 Andersen, Torben. Currency and Interest Rate Hedging. Simon and Schuster, 1993. 
 Beidleman, Carl. Financial Swaps. Dow Jones-Irwin, 1985. 
 Hull, John C. Options, Futures and Other Derivative Securities. 2d ed. Prentice Hall, 1989. 

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