FX Spot & Forwards

FX forwards are agreements between parties to exchange currencies for a set price and quantity at some future date. The forward points, represents the difference between the spot FX rate and the FX forward rate, at a predefined future date. The currency settlement of that transaction occurs on the future/forward date. FX forward contracts are useful for hedging purposes but are also traded for speculative reasons.

The key participants in the FX forwards market include commercial, investment, and central banks, as well as dealers, brokers, and speculators. Large commercial and investment banks make up significant portion of FX forward trading not only for themselves (speculative) but also on behalf for their customers.

A non-deliverable forward (NDF) is a cash-settled, and usually short-term, forward contract. An NDF is a two-party currency derivatives contract to exchange cash flows between the NDF and prevailing spot rates. One party will pay the other the difference resulting from this exchange.

The notional amount is never exchanged/settled, hence the name “non-deliverable.” Two parties agree to take opposite sides of a transaction for a set amount of money—at a contracted rate, in the case of a currency NDF. This means that counterparties settle the difference between contracted NDF price and the prevailing spot price. The profit or loss is calculated on the notional amount of the agreement by taking the difference between the agreed-upon rate and the spot rate at the time of settlement.

The fixing date is the date at which the difference between the prevailing spot market rate and the agreed-upon rate is calculated. The settlement date is the date by which the payment of the difference is due to the party receiving payment.

NDFs are most frequently quoted and settled in U.S. dollars and have become a popular instrument for corporations seeking to hedge exposure to illiquid currencies.

Given the ability to borrow money in one currency, convert to another, then lend in that currency and convert the proceeds back into the initial currency to pay back the original loan, there is an arbitrage-driven relationship between forward FX rates and interest rate differentials.

This arbitrage strategy is known as covered arbitrage, but given the credit risks and transaction costs associated with such a strategy, actual arbitrage opportunities are rare.  Nevertheless, the mathematical relationship between forward FX and rates is fundamental to fair value pricing for a range of cross-currency instruments and securities.