SCHEDULE I: Instruments for the Management of Foreign-Exchange Exposure
Spot Foreign-Exchange Contract
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An exchange rate is the value of one currency expressed in terms of another currency.
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The spot value refers to the exchange rate where settlement will be made not more than two business days from the contract date (today).
Quoting Spots
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An example of a spot quote is NZD / USD 0.5650.
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This means that 1 NZD = 0.5650 USD.
Forward Foreign-Exchange Contract
- A forward exchange rate (FWD) is a rate agreed today at which one currency is sold/bought against another for delivery on a specified future date.
Calculating Forwards
- The forward price of a currency is not a forecast of where the value of that currency will be, or is expected to be, at a given future date.
- Instead, it is a reflection of interest-rate differentials between countries/ currencies.
Example:
A hypothetical example of the calculation of a forward exchange rate follows:
Assumptions -
- US $600,000 payment to be made in six months’ time
- Spot exchange rate is NZ $1 = US $0.55
- NZ interest rate is 6% per annum
- US interest rate is 1.5% per annum
The forward rate would be calculated as follows:
Suppose a department needs to pay US $600,000 for computer equipment in six months’ time. The department has two options:
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It can borrow NZ $1,082,758.88 now and sell that amount now at the spot rate of 0.55 to buy US $595,533.50. The USD can then be invested at 1.5% for six months to give US $600,000 on the payment date. The company would then have to pay back NZ $1,115,241.65 (NZ $1,082,758.88 borrowed @ 6% for six months); or
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The department can transact now at a FX forward rate of 0.538 to sell NZ $1,115,241.65 to buy US $600,000 in six months time.
The economics of both options are the same. The benefit of option 2 is that it is a simpler solution because there are fewer transactions involved.
