The Colour of Money
14th May, 2012
Series on Forex Hedging
peaking to a number of exporters, importers, CFOs over the last several
years, I have felt that most people find forex to be a toughbeast to
tame and view it with fear. Granted, managing forex risk is not easy,
but it is not impossible either. To start with, there is a need to throw
light on some fundamental concepts of forex risk management.
In this series of articles, I will deal with questions such as:
The Forward is not a Forecast
This might be a little basic for old hands in the market, but there is often a misconception among new entrants
that the Forward Rate is a forecast of where the rate is going. For instance, if on 09-May the Dollar-Rupee Spot
rate is 52.82 and the Forward Rate for 30-June is 54.39, many people think that market is expected to be at 54.39
on 30-June. This is not the correct interpretation.
FUNCTION OF INTEREST RATE DIFFERENTIALS
In the forex market, the Forward Rate is not a forecast. It is simply the rate at which the market is ready to
transact today, for a future date. Therefore, 54.39 is the rate at which the market is willing, on 09-May, to transact
for value date 30-June. Thatís it. The actual rate on 30-June is quite likely to be either much higher (maybe 55.30)
or much lower (maybe 52.00) than 54.39.
Yes, this does not seem to make sense. Why should the market transact at 54.39 for 30-June if the rate is not expected
to be at or near 54.39 on 30-June? How can the banks (the dominant players in the forex market) risk a loss? The fact
is that the banks are not taking a view on the future exchange rate when transacting a Forward Rate. They are really
lending one currency and borrowing another currency for the same stated value date (or maturity date) and the Forward
Rate is calculated so as to bridge the interest rate differential between the two currencies. Thus, neither of the banks
on either side of the trade stands to make a loss from an interest rate perspective. This is how the forex forward rate
came into being and is arrived at even today. The forward rate is simply a function of the interest rate differential
between two currencies. It is not the expected future exchange rate.
Hard to believe? OK, hereís proof. The interest rates in USA and Europe being very low, the interest rate differential
between the USD and the EUR is negligible. As such, the forward rate for the EURUSD is almost the same as the spot rate.
For instance, on 14-May, the 3-mth USD Libor
is 0.47% while the 3-mth EUR Libor
is 0.62%. Thus, the interest rate
is 0.15% and the 3-mth EURUSD forward rate is 1.2894, which is almost the same as the spot rate of 1.2887.
If the forward rate were the forecast of where the market is going to be in the future, the implication of the above
paragraph would be that the EUR-USD rate should not go anywhere for the next three months; or in other words, the rate
is going to be same three months hence. However, we know that this is not possible. The Euro has at least a 66.7%
chance of moving around (whether up or down) rather than remaining static. Therefore, whatever else it may be, the
forward rate is not a forecast for the future.
The above is especially true of forward exchange rates among countries which have allowed free flow of capital between
themselves, or countries with full capital account convertibility. Even in India, which has limited capital account
convertibility, the interest rate differential between USA and India now influences the short-term forward rate to a
large degree, especially given the fact that progressively larger amounts of debt inflows are being allowed into the
country which the foreign investors are allowed to hedge in the
MARKET MOVES DIFFERENT FROM FORWARDS
In India, the forward US Dollar is usually quoted at a premium to the Rupee, or, the Forward Rate is higher than the
Spot rate. If the forward rate were to be a relatively accurate forecast of future Spot, then the Rupee ought to have
depreciated against the Dollar all the time, it should never have appreciated. However, we have seen episodes of
significant Rupee appreciation - from 49 to 39 (2002-2008), from 52.18 to 43.85 (2009 to 2011) and from 54.30 to
48.60 (2011 to 2012).
Yes, the Futures in other markets such as commodities, interest rates and equities, could be taken as the prevailing
market consensus about where the market rates will end up in the future, but not so in the forex market. This is a
peculiarity of the forex market. Most people who enter the forex market harbour this misconception initially, but
it is thankfully corrected pretty soon.
So, next time you want to know where Dollar-Rupee is going to be in the future, donít rely on the Forward. Look for a
The above views are based on the latest available information. Though
the information sources are believed to be reliable, the information is
not guaranteed for accuracy. While the views are proffered with the best
of intentions, neither the author, nor the firm are liable for any
losses that may occur as a result of any action based on the above.
World financial markets, and especially the Foreign Exchange markets,
are inherently risky and it is assumed that those who trade these
markets are fully aware of the risk of real loss involved. Past
performance is not necessarily an indicator of future performance.