Calculating fx forward points

A common misunderstanding we often encounter relates to the calculation of foreign exchange forward points. Foreign exchange forward points are the time value adjustment made to the spot rate to reflect a future date. The forward foreign exchange market is very deep and liquid and is used by an array of participants for trading and hedging purposes. In the corporate world many importers and exporters hedge future foreign currency commitments or forecasts using forward exchange contracts (FECs).

The table below shows a selection of the forward points and outright rates for a number of currency pairs:

Forward points

Table 1: Forward points and outright rates

For example the NZD/USD 1-year forward points are currently -270, while the NZD/USD spot rate is 0.8325. Therefore, at today’s rates a forward rate of 0.8325 – 0.0270 = 0.8055 can be secured for a commitment or forecast in one year’s time. But how did the NZD/USD 1-year forward points come to be -270? The common misunderstanding is that they are traded like the spot rate i.e. based on currency traders’ views for the outlook of a currency’s fundamentals. This is incorrect. FX points are mathematically derived by the prevailing interest rate markets. Using our example of the NZD/USD 1-year forward points the -270 is a result of the 1-year US and NZ interest rate outlook. The NZD/USD is a good example because of the significant interest rate differentials between the two currencies. The aggressive monetary easing policies in the US have resulted in an extremely low interest rate environment. This contrasts with NZ which although has interest rates at historically low levels, they remain well above those of the US. The chart below shows the NZ interest rate yield curve versus the US and the corresponding fx forward points.

NZ and US int rates and fx points

Chart 1: NZ and US interest rates and the NZD/USD forward points

The interest rate market is telling us that the US 1-year swap rate is 0.25% while in NZ it is 3.45%. So how does this equate to -270 fx points?

Example

USD1,000,000 at a spot rate of 0.8325 = NZD1,201,201

If USD1,000,000 is invested for one year at a US interest rate of 0.25% per annum, at the end of one year USD1,000,000 is USD1,002,500.

If NZD1,201,201 is invested for one year at a NZ interest rate of 3.45% per annum, at the end of one year NZD1,201,201 is NZD1,242,643.

The equivalent exchange rate is NZD1,242,643 divided by USD1,002,500 = 0.8067.

0.8067 – 0.8325 = -0.0258 (or -258 fx points in the parlance of the fx markets).

The bid/ask spread of the fx and interest rate markets accounts for the 12 fx point balance. The example serves to provide a “back of the envelope” guide to calculating fx forward points and outright rates.

Even though the calculation of the forward points is mathematically derived from the interest rate market, interest rates themselves are the market’s expectation of the outlook for an economy’s fundamentals i.e. subjective. Therefore the fx forward points are derived from traders positioning on interest rate differentials.

Exporters from countries with higher interest rate environments such as New Zealand and Australia benefit from the negative forward points, while it is a cost to importers. An exporter wants a weak base currency so large negative forward points are an economic advantage. With an upward sloping interest rate yield curve (or more correctly positive interest rate differential) forward points will be more negative the longer the time horizon.

An importer wants a strong currency therefore negative forward points are detrimental to the hedged conversion rate. The impact of negative forward points is a reason that exporters often have longer term hedging horizons compared to importers because the impact of forward points are not penal.

Forward exchange contracts are therefore a flexible, and relatively easy to understand, hedging tool that is commonly used to bring certainty to those grappling with foreign exchange exposures and the volatility of the financial markets.

Graduate opportunity at Hedgebook Ltd

Product Solutions Co-ordinator

This is a great opportunity for a graduate, or recent graduate, to join a dynamic organisation providing cloud based financial market solutions.

The Company

Hedgebook Limited is a leading edge SAAS company which is expanding globally. We develop financial risk management tools that help organisations better manage their foreign exchange and interest rate risks. The changing global regulatory and compliance environment has meant an increased demand for Hedgebook’s products. Although in a relatively early stage of development we already have clients in Europe and Australia as well as New Zealand.

We are a small team and so the ability to work independently but professionally is essential but equally you will enjoy the flexibility of a small company.

The Role

Due to a recent acquisition we are looking to fill the position of Product Solutions Co-Ordinator to carry out the daily functions associated with running Hedgebook’s financial market data system.

Some of the day to day tasks include:

  • Processing End of Day and real time data from our data providers on a timely and accurate basis
  • Administering NZ and Australian equity corporate actions
  • Adding relevant news releases to the website
  • Managing customer access to  their subscribed data packages
  • Dealing with customer queries and escalating as appropriate
  • Following daily procedures involving multiple databases to facilitate the smooth running of the delivery of data

As you become confident in the role there will be opportunities to contribute to other parts of the business.

Due to the nature of the position, some extended hours will be required.

What you will need to bring to the role

To be successful in this role we are looking for someone with the following attributes and qualifications:

  • A tertiary qualification that has ideally included finance papers
  • An advanced user of MS Excel, highly competent in MS Word and other MS Office products
  • An interest in database management and financial markets
  • An excellent command of written and spoken English
  • An eye for detail
  • The ability to fit into a small and highly focused team of professionals.

Applicants must be eligible to work in New Zealand.

CVs can be sent along with a covering letter to duncan.shaw@hedgebook.co.nz.

 

Will auditors enforce CVA compliance?

There is no doubt that CVA (credit value adjustment) and DVA (debit value adjustment) is rapidly becoming front of mind as corporations who have a 31 December balance date and outstanding financial instruments discover something else that needs to be calculated for inclusion in the annual accounts.

The world has changed from when a valuation was just something you took from the bank, plugged into the accounts and moved on. First it was sensitivity analysis on the outstanding instruments. What would the effect be if exchange rates moved up 10% or interest rates moved down 1%? Interesting, but not necessarily that important, especially as this analysis is only on the hedged position not on what isn’t hedged. If you have only hedged 20% of your expected future exposure because you are waiting for the exchange rate to move in your favour, then you will know the effect on 20% of your business, but not the other 80%. The sophisticated investor might look through this, most won’t.

Now we have something called CVA and DVA to consider when we value a financial instrument. What is the impact if my counterparty falls over, or if I fall over, on the value of my outstanding instruments? Interesting, however more relevant during and immediately after the GFC. Less so now and not straightforward to calculate, by any means. However, it is a requirement under the recently released IFRS 13, and not something your bank is going to provide.

How hard will the auditors push to have these numbers included is up for debate. Some of the numbers are immaterial. If you have short dated foreign exchange deals, the numbers are small; if you have long dated interest rate swaps the numbers are more material. Either way they are not something that can be calculated on the back of an envelope.

Hence the problem for CFOs and auditors. The standards have moved down a path whereby the fair value of a financial instrument is not straightforward anymore, nor easily obtained. The relevant purpose is debateable and already the cries of “enough already” can be heard by CFOs who have enough to worry about without debating the benefits or otherwise of the new standards. Likewise the audit dollar is getting squeezed at every turn in an environment where the audit itself is under more scrutiny and regulation.

CFOs may be quite justified to push back when it comes time to including CVA in their valuations, given the usefulness and materiality of the numbers. Whether the audit fraternity accept this or not is too early to tell – material or not you still need to calculate the numbers to decide on their materiality. Whatever the result it will be fascinating to see how this plays out and whether the standards come out on top or the tide of CFO pressure prevails.