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How interest rates impact FX forward prices

 

A FX Forward Contract

Businesses that regularly use FX forward contracts to manage currency risk will probably be aware that the forward price they receive from their FX provider is the sum of the spot rate and the “forward points”. There can be an adjustment on the FX forward pricing which can be a positive or a negative. What may be less well understood is that the forward points are a purely mathematical calculation based on the gap in term interest rates between the two currencies.

FX Forward Pricing: Why is this important?
Well, it’s important because a raft of central banks have been cutting their benchmark interest rates in 2020. The US Federal Reserve cut its Fed Funds rate by 1.25% and the Bank Of England were also active, cutting by 0.5%. These rate cuts meant that global benchmark interest rates have converged. The narrowing disparity now in rates between countries has narrowed the gap between spot and FX forward rates. 
 

 

FX Forward

FX Forward: Winners and Losers

Chart 1 illustrates how the gap between both US and UK interest rates and between US and Euro interest rates have halved since the start of 2019. As a result, 12 month forward points for GBPUSD have narrowed from +2.25c to +0.35c and for EURUSD, forward points have narrowed from +3.6c to +1.25c.

Unfortunately, lower forward points has made forward hedging less attractive for dollar buyers who would previously have been able to secure a 12 month forward rate 2.25c above the spot rate when selling sterling and 3.6c above spot when selling euros.

The corollary is that pricing is now a lot more attractive for exporters who sell in dollars as they can now lock in a FX forward rate that is very close to the current spot price, removing this disincentive to hedge especially for longer dates. The change in forward points alone has provided a UK based exporter with US$1m in revenue with a saving of £3,000 on a 3 month GBPUSD forward and a £12,600 benefit on a 12 month forward as compared to rates available a year ago. For a euro based exporter, the savings are even larger at €3,800 and €15,200 respectively.

Window Forward vs Fixed Forward 

Tactically, the smaller forward point adjustments mean that Window Forwards may now look a better alternative to Fixed Forwards. Open window forwards provide a firm with the flexibility to use a FX forward contract within a chosen period instead of to a specified fixed date and is a better, more accommodating solution when there is uncertainty around the date of the payment or receipt of currency.

 Previously, the greater flexibility offered by an open window forward had come at a cost as the firm would have been charged the forward points to the end of the window (if a cost) or received the forward points to the start of the window (if a benefit) but as the forward price adjustment has moved closer to zero, so has the cost of flexibility; a real benefit in these uncertain times.

How Vuca Treasury can help

With multi-decade experience of the financial and capital markets, we’ve pretty much seen it all! Contact Vuca Treasury at info@vucatreasury.com to see how we can help you optimise the way you manage currency and other financial risks within your business. 

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For 2022, markets have priced in three rate hikes from the Bank of England, and one hike from the ECB. Why not speak to one of our experts to see how this might impact your debt covenants and cashflow? Or find out how you could optimise your hedge with a few simple steps.

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Central Bank Rates 2022