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Foreign currency forward agreements are contracts in which parties agree to exchane one currency for another on a specific date, at a specific rate of exchange. Because forward contracts are financial instruments that fix future exchange rates, they are commonly used as hedging vehicles. This article discusses forward pricing and explores some innovative uses of forwards as hedging tools and as investment vehicles.
PRTCING
The no-arbitrage constraint demands that investing in a risk-free foreign bond currency hedged with a forward contract will give the same return as investing in a risk-free domestic bond with the same maturity. This constraint is also known as covered interest arbitrage.
If the foreign interest rate is greater than the domestic interest rate, selling the foreign currency forward will result in a loss relative to the current spot rate. This is known as the cost of hedging. Conversely, buying the foreign currency forward (under the same interest rate conditions) will result in a gain relative to the spot exchange rate. This is sometimes referred to as positive carry. Forward contract settlement occurs on the expiry date. Unlike options, forwards do not have any initial premium.
The graph below illustrates the sensitivity of the Deutschmark forward exchange rate versus two interest rate environments. This chart plots the one-year forward rate against German and US interest rates where the current dollar/Deutschmark spot exchange rate is DM1.7000/US$.
FORWARD AGREEMENTS IN INTERNATIONAL INVESTMENT PORTFOLIOS
As portfolio managers have increased their allocation of international assets, the need to address foreign currency risk has grown. For brevity, foreign exchange management is divided into two broad categories, passive and active. Passive hedges are constant currency positions. These may be fully hedged, unhedged or something in between. Active strategies manage their exposures. Some investment philosophies inspire active strategies which have currency positions without underlying asset exposure. This style views currencies as an asset class.
Forwards can play a key role in implementing either passive or active currency management strategies. Because forward contracts fix future exchange rates, they are useful instruments when hedging future coupon or dividend payments. Further, because forward agreements are traded over-thecounter (OTC), the contract specifications such as...