CME Australian Dollar
C. Currency Forecasting Service
The corporate need to forecast currency values has prompted the emergence of several consulting firms, including Business International, Conti Currency, Predex, and Wharton Econometric Forecasting Associates (WEFA). In addition, some large investment banks, such as Goldman Sachs, and commercial banks, such as Citibank, Chemical Bank, and Chase Manhattan Bank, offer forecasting services. Many consulting services use at least two dif- ferent types of analysis to generate separate forecasts, and then determine the weighted average of the forecasts.
Some forecasting services, such as Capital Techniques, FX Concepts, and Preview Econom- ics, focus on technical forecasting, while other services, such as Corporate Treasury Consultants Ltd. and WEFA, focus on fundamental forecasting. Many services, such as Chemical Bank and Forexia Ltd., use both technical and fundamental forecasting. In some cases, the technical forecasting techniques are emphasized by the forecasting firms for short-term forecasts, while fundamental techniques are emphasized for long-term forecasts.
Recently, most forecasting services have been inaccurate regarding future currency values.
Given the recent volatility in foreign exchange markets, it is quite difficult to forecast currency EXHIBIT 57
Forecasts of Malaysia’s Ringgit Drawn from Each Forecasting Method
Method Factors Considered Situation Possible Forecast Fundamental Inflation, interest rates,
economic growth
Malaysia’s interest rates are high while inflation rate is stable
The ringitt’s value will go up as U.S. investors take advantage of the high interest rates by investing in Malaysian securities Technical Recent movements—chart
and trend
The ringgit’s value fell in the past few weeks below a specific threshold level
The ringitt’s value will continue to decline now that it is beyond the threshold level Market-based Spot rate, forward rate The ringitt’s forward rate
shows a significant discount, which is due to Malaysia’s relatively high interest rates
Based on the predicted forward rate discount, the ringitt’s value will fall
Mixed Weighted average Interest rates are high;
forward rate discount displayed; the ringitt’s value of recent weeks has headed lower
There is better than 50%
chance that the ringitt’s value will decline
FOREIGN EXCHANGE RATE FORECASTING
123
values. One way for a corporation to determine whether a forecasting service is valuable is to compare the accuracy of its forecasts to those of alternative publicly available and free forecasts. The forward rate serves as a benchmark for comparison here, because it is quoted in many newspapers and magazines. A recent study compared the forecasts of several currency forecasting services regarding nine different currencies to the forward rate. Only 5% of the forecasts (when considering all forecasting firms and all currencies forecasted) for one month ahead were more accurate than the forward rate, while only 14% of forecasts for three months ahead were more accurate. These results are frustrating to the MNCs that have paid $25,000 or more per year for expert opinions. Perhaps some corporate clients of these consulting firms believe the fee is worth it even when the forecasting performance is poor, if other services (such as cash management) are included in the package. It is also possible that a corporate treasurer, in recognition of the potential for error in forecasting exchange rates, may prefer to pay a consulting firm for its forecasts. Then the treasurer is not (in a sense) directly responsible for corporate problems that result from inaccurate currency forecasts. Not all MNCs hire consulting firms to do their forecasting. For example, Kodak, Inc. once used a service, but became dissatisfied with it and has now developed its own forecasting system.
See also FUNDAMENTAL FORECASTING; MARKET-BASED FORECASTING; MIXED FORECASTING; TECHNICAL FORECASTING.
FOREIGN EXCHANGE RATE RISK See CURRENCY RISK.
FOREIGN EXCHANGE RISK See CURRENCY RISK.
FOREIGN EXCHANGE RISK PREMIUM
The foreign exchange risk premium is the difference between the forward rate and the expected future spot rate.
FOREIGN MARKET BETA
A foreign market beta is a measure of foreign market risk which is derived from the Capital Asset Pricing Model (CAPM). The formula for the computation is:
EXAMPLE 51
If the correlation between the German and U.S. markets is 0.44, and the standard deviations of German and U.S. returns are 20.1% and 12.5%, respectively, then the German market beta is
In other words, despite the greater riskiness of the German market relative to the U.S. market, the low correlation between the two markets leads to a German market beta (.76) which is lower that the U.S. market beta (1.00).
Foreign market beta = Correlation with the U.S. market Standard deviation of foreign market
Standard deviation of U.S. market ---
×
0.76 0.44 0.201 0.125 ---
×
.
= FOREIGN MARKET BETA
124
FOREIGN PORTFOLIO INVESTMENT See PORTFOLIO INVESTMENTS.
FOREIGN SUBSIDIARIES AND AFFILIATES
A foreign subsidiary bank is a separately incorporated bank owned entirely or in part by a U.S. bank, a U.S. bank holding company, or an Edge Act Corporation. A foreign subsidiary provides local identity and the appearance of a local bank in the eyes of potential customers in the host country, which often enhances its ability to attract additional local deposits.
Furthermore, management is typically composed of local nationals, giving the subsidiary bank better access to the local business community. Thus, foreign-owned subsidiaries are generally in a stronger position to provide domestic and international banking services to residents of the host country.
Closely related to foreign subsidiaries are foreign affiliate banks, which are locally incor- porated banks owned in part, but not controlled, by an outside parent. The majority of the ownership and control may be local, or it may be other foreign banks.
FOREX
See FOREIGN EXCHANGE.
FORFAITING
Forfaiting is the simplest, most flexible and convenient form of medium-term fixed rate finance for export transactions. It is a form of export financing similar to factoring, which is the sale of export receivables by an exporter for cash. The word comes from the French à forfait, a term meaning “to forfeit or surrender a right.” It is the name given to the purchase of trade receivables maturing at various future dates without recourse to the exporter. The basic idea is to get the exporter’s goods shipped and received and for the exporter to receive payment for the goods.
The exporter accepts one or a series of bills of exchange payable over a specified period of years.
The exporter immediately turns around and sells these notes or bills of exchange to a forfait house. This sale is made without recourse to the exporter, who now has his goods delivered and the cash in hand. He is out of the picture. The only obligation that he still has is that the goods shipped were of the quality stated. The exporter is now free to go on to the next deal without the worry of extending credit and collecting. This keeps his cash flow moving in a positive direction. A specialized finance firm called a forfaiter buys trade receivables, notes, or bills of exchange and then repackages them for sale to investors. Forfaiting may also carry the guarantee of the foreign government. Under a typical arrangement, the exporter receives cash up front and does not have to worry about the financial ramifications of nonpayment, this risk being transferred to the forfaiter. The forfaiter carries all political, country, and commercial risk.
Forfaiting is the discounting—at a fixed rate without recourse—of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, Deutsche mark). This technique is typically used in the case of capital-goods exports with a five-year maturity and repayments in semiannual installments. The discount is set at a fixed rate—about 1.25% above the local cost of funds or above the London interbank offer rate (LIBOR). In a typical forfaiting transaction, an exporter approaches a forfaiter before completing a transac- tion’s structure. Once the forfaiter commits to the deal and sets the discount rate, the exporter can incorporate the discount into the selling price. Forfaiters usually work with bills of exchange or promissory notes, which are unconditional and easily transferable debt instruments that can be sold on the secondary market. Forfaiting differs from factoring in four ways: (1) forfaiting is relatively quick to arrange, often taking no more than two weeks; (2) forfaiting may be for years, while factoring may not exceed 180 days; (3) forfaiting typically involves political and transfer uncertainties but factoring does not; and (4) factors usually want access
FOREIGN PORTFOLIO INVESTMENT
125
to a large percentage of an exporter’s business, while most forfaiters will work on a one-shot basis. A third party, usually a specialized financial institution, guarantees the financing. Many forfaiting houses are subsidiaries of major international banks, such as Credit Suisse. These houses also provide help with administrative and collection problems.
FORWARD CONTRACT
A forward contract is a written agreement between two parties for the purchase or sale of a stipulated amount of a commodity, currency, financial instrument, or other item at a price determined at the present time with delivery and settlement to be made at a future date, usually in 30, 90, or 180 days.
See also FUTURES; FOREIGN EXCHANGE.
FORWARD DIFFERENTIAL
See FORWARD PREMIUM OR DISCOUNT.
FORWARD-SPOT DIFFERENTIAL See FORWARD PREMIUM OR DISCOUNT.
FORWARD EXCHANGE RATE
The forward exchange rate is the contracted exchange rate for receipt of and payment for foreign currency at a specified date in the future, at a stipulated current or spot price. In the forward market, you buy and sell currency for a future delivery date, usually 1, 3, or 6 months in advance. If you know you need to buy or sell currency in the future, you can hedge against a loss by selling in the forward market. By buying and selling forward exchange contracts, importers and exporters can protect themselves against the risks of fluctuations in the current exchange market. Suppose that the spot and the 90-day forward rates for the British pound are quoted as $1.5685 and $1.5551, respectively. You are required to pay £10,000 in 3 months to your English supplier. You can purchase £10,000 today by paying $15,551 (10,000 ×
$1.5551). These pounds will be delivered in 90 days. In the meantime you have protected yourself. No matter what the exchange rate of the pound or U.S. dollar is in 90 days, you are assured delivery at the quoted price. As can be seen in the example, the cost of purchasing pounds in the forward market ($15,551) is less than the price in the spot market ($15,685).
This implies that the pound is selling at a forward discount relative to the dollar, so you can buy more pounds in the forward market. It could also mean that the U.S. dollar is selling at a forward premium. Note: It is extremely unlikely that the forward rate quoted today will be exactly the same as the future spot rate.
See also SPOT EXCHANGE RATE.
FORWARD FOREIGN EXCHANGE MARKET
Simply called forward market, the forward foreign exchange market is the market where foreign exchange dealers can enter into a forward contract to buy or sell any amount of a currency at any date in the future. Forward contracts are negotiated between the offering bank and the client as to size, maturity, and price. The rationale for forward contracts in currencies is analogous to that for futures contracts in commodities; the firm can lock in a price today to eliminate uncertainty about the value of a future receipt or payment of foreign currency. Such a transaction may be undertaken because the firm has made a previous contract, for example, to pay a certain sum in foreign currency to a supplier in three months for some needed inputs to its operations. This concept is called hedging. The principal users of the forward market are currency arbitrageurs, hedgers, importers and exporters, and speculators.
FORWARD FOREIGN EXCHANGE MARKET
126
Arbitrageurs wish to earn risk-free profits; hedgers, importers, and exporters want to protect the home currency values of various foreign currency-denominated assets and liabilities; and speculators actively expose themselves to exchange risk to benefit from expected movements in exchange rates. It differs from the futures market in many significant ways.
See also FUTURES; HEDGE.
FORWARD MARKET
See FORWARD FOREIGN EXCHANGE MARKET.
FORWARD MARKET HEDGE
A forward market hedge is a hedge in which a net asset (liability) position is covered by a liability (asset) in the forward market.
EXAMPLE 52
XYZ, an American importer, enters into a contract with a British supplier to buy merchandise for £4,000. The amount is payable on delivery of the goods, 30 days from today. The company knows the exact amount of its pound liability in 30 days. However, it does not know the payable in dollars. Assume further that today’s foreign exchange rate is $1.50/£ and the 30-day forward exchange rate is $1.49. In a forward market hedge, XYZ may take the following steps to cover its payable.
Step 1. Buy a forward contract today to purchase (buy the pounds forward) £4,000 in 30 days.
Step 2. On the 30th day pay the foreign exchange dealer $5,960.00 (4,000 pounds × $1.49/£) and collect £4,000. Pay this amount to the British supplier.
By using the forward contract, XYZ knows the exact worth of the future payment in dollars ($5,960.00). The currency risk in pounds is totally eliminated by the net asset position in the forward pounds.
Note: (1) In the case of the net asset exposure, the steps open to XYZ are the exact opposite:
Sell the pounds forward (buy a forward contract to sell the pounds), and on the future day receive and deliver the pounds to collect the agreed-upon dollar amount. (2) The use of the forward market as a hedge against currency risk is simple and direct. That is, it matches the liability or asset position against an offsetting position in the forward market.
See also MONEY-MARKET HEDGE.
FORWARD PREMIUM OR DISCOUNT
The forward rate is often quoted at a premium to or discount from the existing spot rate. The forward premium or discount is the difference between spot and forward rates, expressed as an annual percentage, also called forward-spot differential, forward differential, or exchange agio. When quotations are on an indirect basis, a formula for the percent-per-annum forward premium or discount is as follows:
where n = the number of months in the contract.
Forward premium ( )+ or discount ( )− Spot–Forward Forward
--- 12 ---n ×100
×
=
FORWARD MARKET
127
EXAMPLE 53
Assume that the spot exchange rate = ¥110/$ and the one-month forward rate = ¥109.66/$. Since the spot rate is greater than the one-month forward rate (in indirect quotes), the yen is selling forward at a premium.
The 1-month (30-day) forward premium (discount) is:
The 3-month (90-day) forward premium (discount) is:
[(¥110.19 − ¥108.55)/¥108.55] × 12/3 × 100 =+6.04%
The 6-month (180-day) forward premium (discount) is:
[(¥110.19 − ¥106.83)/¥106.83] × 12/6 × 100 =+6.29%
Note: A currency is said to be selling at a premium (discount) if the forward rate expressed in indirect quotes is less (greater) than the spot rate.
With direct quotes:
Note: A currency is said to be selling at a premium (discount) if the forward rate expressed in direct quotes is greater (less) than the spot rate.
Exhibit 58 shows forward rate quotations and annualized forward premiums (discounts).
Note: In Exhibit 58, since a dollar would buy fewer yen in the forward than in the spot market, the forward yen is selling at a premium.
FORWARD RATE
See FORWARD EXCHANGE RATE.
EXHIBIT 58
Forward Rate Quotations and Annualized Forward Premiums (Discounts)
Quotation ¥/$ (Indirect Quote) $/¥ (Direct Quote) % per Annum
Spot Rate ¥110.19 $0.009075
Forward
1-month 109.66 0.009119 +5.80%
3-month 108.55 0.009212 +6.04%
6-month 106.83 0.009361 +6.29%
¥110.19–¥109.66
¥109.66
--- 12 ---1 ×100
× = +5.80%
Forward premium or discount Forward–Spot ---Spot 12
---1 ×100
×
=
Forward premium or discount $0.009119–$0.009075
$0.009075
--- 12 ---1 ×100
× +5.80%
= =
FORWARD RATE
128
FORWARD RATE QUOTATIONS
The quotations for forward rates can be made in two ways. They can be made in terms of the amount of local currency at which the quoter will buy and sell a unit of foreign currency.
This is called the outright rate and it is used by traders in quoting to customers. The forward rates can also be quoted in terms of points of discount and premium from spot, called the swap rate, which is used in interbank quotations. The outright rate is the spot rate adjusted by the swap rate. To find the outright forward rates when the premiums or discounts on quotes of forward rates are given in terms of points (swap rate), the points are added to the spot price if the foreign currency is trading at a forward premium; the points are subtracted from the spot price if the foreign currency is trading at a forward discount. The resulting number is the outright forward rate. It is usually well known to traders whether the quotes in points represent a premium or a discount from the spot rate, and it is not customary to refer specifically to the quote as a premium or a discount. However, this can be readily determined in a mechanical fashion. If the first forward quote (the bid or buying figure) is smaller than the second forward quote (the offer or selling figure), then it is a premium—that is, the swap rates are added to the spot rate. Conversely, if the first quote is larger than the second, then it is a discount. (A 5/5 quote would require further specification as to whether it is a premium or discount.) This procedure assures that the buy price is lower than the sell price, and the trader profits from the spread between the two prices. For example, when asked for spot, 1-, 3-, and 6-month quotes on the French franc, a trader based in the United States might quote the following:
.2186/9 2/3 6/5 11/10
In outright terms these quotes would be expressed as indicated as follows:
Notice that the 1-month forward franc is at a premium against the dollar, whereas the 3- and 6-month forwards are at discounts. Note: The literature usually ignores the existence of bid and ask prices, and, instead, uses only one rate, which can be treated as the midrate between bid and ask prices.
FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT RATES Because of a widespread belief that foreign exchange markets are “efficient,” the forward currency rate should reflect the expected future spot rate on the date of settlement of the forward contract. This theory is often called the expectations theory of exchange rates.
EXAMPLE 54
If the 90-day forward rate is DM 1 = $0.456, arbitrage should ensure that the market expects the spot value of DM in 90 days to be about $0.456.
An “unbiased predictor” intuitively implies that the distribution of possible future actual spot rates is centered on the forward rate. This, however, does not mean the future spot rate will actually be equal to what the future rate predicts. It merely means that the forward rate will, on
Maturity Bid Offer
Spot .2186 .2189
1-month .2188 .2192
3-month .2180 .2184
6-month .2175 .2179
FORWARD RATE QUOTATIONS
129
average, under- and over-estimate the actual future spot rates in equal frequency and degree. As a matter of fact, the forward rate may never actually equal the future spot rate.
The relationship between these two rates can be restated as follows:
The forward differential (premium or discount) equals the expected change in the spot exchange rate.
Algebraically, With indirect quotes:
With direct quotes:
The relationship between the forward rate and the future spot rate is illustrated in Exhibit 59.
See also APPRECIATION OF THE DOLLAR; PARITY CONDITIONS.
EXHIBIT 59
Relationship Between the Forward Rate and the Future Spot Rate
Difference between forward and spot rate F–S
---S
equals Expected change in spot rate S2–S1
S1 ---
Spot–forward
---Spot Beginning rate–ending rate Ending rate ---
=
Forward–Spot Forward
--- Ending rate–beginning rate Beginning rate ---
=
Parity line 5
4 3 2 1
1 2 3 4 5
-1
I
J
-1 -2 -3 -4 -5
-2 -3 -4 -5 Expected change in home currency value of foreign currency (%)
Forward premium (+) or discount (-) on foreign currency (%) FORWARD RATES AS UNBIASED PREDICTORS OF FUTURE SPOT RATES