How to buy currency at a price “from the future”: Futures and Forwards

In our blog on Habré we already talked about derivative financial instruments and, in particular, futures . Today we’ll talk about how these tools work when applied to currencies.

Back to the Future: Forward Contract

Not the most obvious idea, but the exchange rate for a date in the future is not an unknown value - it is known right now. Of course, we are not talking about predicting what the rate of a particular currency will be in reality - only psychics or analysts can make such predictions (moreover, when predicting the rate for a specific date, there is not such a big difference between them).

The price at which you can make a deal with currency with settlements on a specific date in the future is known. Moreover, such an opportunity is provided by both banks and the Moscow Exchange - this is a futures / forward contract that fixes the price (exchange rate) for a future date.

Such contracts for the purchase and sale of currency for any dates have been concluded for many years by banks and their customers. It’s convenient for business - I signed a contract for the supply of equipment, bought a forward, and don’t have to worry about possible movements in the wrong direction.

All this happened within the limits of credit risk, but then the situation changed. Problems in the country's economy, caused by sanctions and lower oil prices, led to difficulties both in the real sector and in the banking sector. Reliable large banks have completely closed or significantly reduced their limits on customers, and third-tier banks themselves have become a risk to customers. All this led to the virtual lack of the ability to conclude transactions or greatly increased the prices of derivatives.

How much should the forward cost

It is important to understand that the value of a currency by calculations for a certain date in the future has nothing to do with forecasting the exchange rate, but is a mathematical value and is calculated through the value of money in time, that is, the difference in rates between the two currencies.

In other words, to buy dollars for rubles that are not yet available, they must be borrowed. And the difference in a bank loan from a loan in the financial market is only in the rates. The formula for calculating the cost of a forward to buy dollars looks like this:

Стоимость форварда USDRUB = (% ставка*) х (валютный курс) х (дней до исполнения форварда)/365

* - the interest rate here is the interbank swap rate (the values ​​of bank fixes are available here ) The

theoretical price of the forward consists of the exchange rate and the value of the forward (time).

Consider an example of calculating the cost of a forward:

Assume that the exchange rate is 60 rubles per dollar. Forward term = 45 days, rate for 45 days = 11.5%.

In this case, the forward cost will be:

Стоимость форварда = (11,5%)х60х 45/365= 0,85

Теоретическая цена форварда=60+0,85=60,85

The trick is that using a central counterparty removes risks from both sides of the transaction. The counterparty for the parties is NCC Bank, which means the conditions are equal, without a premium for credit risk. Thus, when buying a currency in settlements in the future, the company really buys it now, borrowing rubles for the final settlement at the interbank rate.

Interest Risk vs Cost

Exchange futures are experimented once a quarter. This means that when hedging a business contract by a futures, it becomes necessary to sell it before the expiration date - for example, the day before payment under the contract.

In this case, the selling price will consist of the current rate and time value before expiration at the current interest rate. Since the interest rate on the day the futures are bought and sold may not coincide, interest rate risk appears.

Interest rate risk = (change in% rate) x (exchange rate) x (days before the execution of the futures) / 365

Example of calculating interest rate risk:

• Suppose that it is necessary to sell futures 45 days before its expiration;
• The current interest rate is 11.5%;
• The rate is 60 rubles per US dollar;
• Estimated interest rate reduction of 1%.

In this case, the interest risk will be calculated by the formula:

Процентный риск = 1%х(60) х 45/365 = 0,0739

That is, a change in interest rates by one percent, when selling futures 45 days before expiration, is 7.3 kopecks per dollar.

Forwards and futures

Forward contracts can be concluded at any date, for example, exactly under the contract for the supply of equipment concluded by the company. They do not have interest risk (there is no need for an early sale), they are usually more expensive than futures.

In this case, the decision on whether to take on interest risk (that is, the choice between using futures and forwards) will depend on the expectations of the company's financial director regarding changes in interest rates, as well as on the reasonableness of the forward premium compared to futures. To calculate the premium you need to calculate the rate based on the futures quotes and the exchange rate on the exchange, and then based on this rate determine the fair price of the forward for the required date.

Small life hack:

On the Exchange, it is possible to conclude delivery deals with currencies up to 365 days, which are actually full counterparts of forwards in terms of interest rate risk and futures in terms of securing transactions.

Conclusion

The main difficulty when working through the Exchange is the need to make guarantee collateral for transactions. The limit from a reliable bank removes this need for collateral - this is the most obvious and significant plus in favor of using the OTC market.

If there is no limit from the bank from the top ten, you should not try your luck. The Moscow Exchange provides a much more transparent mechanism for working on the basis of collateral. Pricing is understandable, there is the possibility of targeted transactions with the same banks, and the risks associated with the execution of transactions tend to zero.

The ITinvest website provides detailed information on the purchase of currency in the present and future on the Moscow Exchange for companiesand private investors. In addition, we have implemented a special calculator with which you can calculate the benefits when purchasing currency in the financial market, and not in a bank.

That's all for today, thanks for watching! Do not forget to subscribe to our blogs on Habré and Geektimes .

Posted by Philip Agrachev, Managing Director of IT Invest