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:
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.
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?
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.