Forward rate agreement is one of the most popular financial instrument in the over-the-counter instrument category. This is not regulated by the exchange hence a higher risk profile as compared to future, yet due to its wide ranging utility in the financial market, it remains a very popular derivative.
Here is a quick guide and discussion on various aspects of forward rate agreement. Please read, and leave your query, suggestion and feedback.
1. Learning Objectives
Learn the key features on a FWC
Explain why an investor would trade a FWC
Understand the full cycle of a FWC
o Initiating trade – Open a contract
o Month end valuation
o Liquidating trade – Close a contract
o Take delivery
2. Content
A forward contract (FWC) can be defined as an agreement to buy or sell an asset (usually a currency) at a future date for a specified price. It is considered to be a “derivative” financial instrument. The characteristics of a forward contract are:
FWC’s are not traded for cash initially. The investor enters into a contract. For accounting purposes, forward contracts are regarded as “off balance sheet” items, meaning that only unrealized gains/losses will be included on the balance sheet and not the cost.
2.1. Key features of a FWC
2.1.1. What is the underlying asset?
The underlying bet is usually on a currency.
2.1.2. Where are FWC’s traded?
FWC’s are contract are traded “over-the-counter” (OTC) which means they are not traded on a regular exchange. They are essentially private deals arranged by your broker. However, despite trading OTC, forward contracts are very liquid, meaning they trade with very high volume.
2.1.3. How is the cash ultimately settled?
The cash settlement of a contract takes place on the maturity date of the contract rather than at the time of the closing trade.
If you sold a FWC on 08/14/20 for a profit, you would not receive your money until the maturity date of the actual contract. The realized P/L would be recognized on 08/14/20 and a receivable would impact on your balance sheet. Then on maturity date, cash would be received and your receivable would be closed.
Alternatively, if you did not close the contract before the maturity date, you have chosen to “take delivery” of the currency at the exchange rate agreed in the opening trade(s).
The maturity date is also known as the settlement date or end date.
2.2. Why do Investors use FWCs?
Hedge funds trade forward contracts for three reasons
1. To hedge foreign currency risk in their portfolios
2. For speculative purposes
3. To hedge foreign currency risk in share classes.
2.2.1. Portfolio Hedging
Hedge funds commonly hold many securities in many different currencies. They need to be concerned with the fluctuation of currency rates because their NAV is ultimately issued as the base currency of the given fund, meaning that all holdings need to be translated into base currency when a NAV is produced.
Let’s say you have a USD fund that wants to invest in a EUR security.
The purchase can be funded in one of two ways
1. Borrow EUR to purchase the EUR security, thereby holding a long position in the EUR security and being short EUR cash.
2. Enter a spot selling USD and buying EUR and use the EUR to purchase the security. This method leaves the fund exposed to EUR/USD currency risk. For example, the EUR security price could increase while the EUR/USD exchange rate weakens, resulting in a loss to the fund overall. To avoid this currency exposure the fund would enter into a forward hedge selling EUR and buying USD.
Let’s look at an example: A fund holds 10,000,000 worth of EUR denominated common stock. When they purchased the shares three months ago, that 10,000,000 EUR were worth 12,875,000 USD. However today that same 10,000,000 EUR might be worth only 12,750,000 USD. Even if the value of your shares in EUR may not have changed, you have lost 125,000 USD worth of your portfolio in USD. For this reason a fund would typically enter a FWC agreeing to SELL 10,000,000 EUR fearing the EUR would drop in value as in this case. The profit earned on the FWC would offset the loss described.
2.2.2. Speculation
A hedge fund may trade currencies as an asset class. A hedge fund may wish to speculate in a currency the same way they speculate in anything else; buy low and sell high. They PURCHASE the currency if they feel it will strengthen and they SELL it if they think it will weaken. Examples are FX Spot, FX Forward and FX Option
2.3. Trading a FWC
2.3.1. Open & Close a FWC
Let’s look at an example. The fund believes the HKD will fall against the USD within the next few months. On 05/17/20, they will transact a sell order for 10,000,000 HKD with a maturity date of 08/30/20 against an amount of 1,291,900 USD.
Each NAV date, this HKD 08/30/20 FWC is priced using Bloomberg forward rates for HKD/USD and the unrealized P/L is recorded on your balance sheet and income statement. The unrealized P/L arises from any movement in HKD/USD rates from that agreed in the contract.
On 07/13/20, the fund decides to close the entire HKD contract by purchasing 10,000,000 HKD against 1,288,000 USD. This would result in a gain of 3,900 USD. The realized P/L of 3,900 USD would be recognized as of the closing trade date of 07/13/20. Also a receivable would impact your balance sheet at the same time. Your position of HKD 08/30/20 would be zero.
The realized P/L occurs because of the movement in the USD/HKD rate from 0.12919 to 0.1288
Finally on 08/30/20, cash for 3,900 USD would come into your broker statement. This cash would relieve your receivable on your balance sheet from 07/13/20.
2.3.2. Take delivery of the FWC
Proceeding with the example above without the closing entry on 07/13/20. What would happen in this case?
Each NAV date, this HKD 08/30/20 FWC is priced and the unrealized P/L is recorded on your balance sheet and income statement.
On 08/30/20, cash for the original amounts flow through your broker statement as follows:
i) 10,000,000 HKD would go out of your HKD broker statement (the fund sold HKD)
ii) 1,291,900 USD would come into your USD broker statement
