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FX Forwards and Futures

Introduction

FX forward contracts are transactions in which agree to exchange a specified amount of different currencies at some future date, with the exchange rate being set at the time the contract is entered into. The date to enter into the contract is called the "trade date", and its settlement date will occur few business days later. The time difference between the trade date and the settlement date is called the "settlement convention". A similar settlement convention exists at the maturity date of the contract, in which physical exchange of the currencies may be delayed as well.

In the FX market, for the trades of any currency against USD, the standard time for the "immediate" settlement convention is usually two business days after the trade date in the other currency. One exception to this convention is CAD, which has one business day delay. Then the "common" settlement convention is the first good business day after this immediate date that follows the holiday conventions of New York and the other currency. For the cross-currency trades in which USD is intermediate currency, the initial settlement convention of each currency is calculated separately with respect to its own conventions. The latest of those two dates is picked as the "immediate" settlement convention. Then the "common" settlement convention moves this immediate date forward to the first good business day that follows the holiday conventions of New York and the two cross currencies.

FX forward rates, FX spot rates, and interest rates are interrelated by the interest rate parity (IRP) principle. This principle is based on the notion that there should be no arbitrage opportunity between the FX spot market, FX forward market, and the term structure of interest rates in the two countries.

Technical Details

FX forward formula

where

FX foward rate= fair forward FX rate (quoted in units of domestic currency per unit of foreign)
Spot FX rate = spot FX rate (quoted in units of domestic currency per unit of foreign)
Domestic interest rate = domestic interest rate (for term of forward) quoted on a simple interest basis
Foreign interest rate = foreign interest rate (for term of forward) quoted on a simple interest basis
Domestic accrual factor = domestic accrual factor
Foreign accrual factor = foreign accrual factor
 

Settlement convention refers to the potential time lag that occurs between the trade and settlement dates. Financial contracts generally have a delay between the execution of a trade and its settlement. This time period is also present between the expiry of an option and its settlement. For example, for an FX forward against USD, the standard date calculation for spot settlement is two business days in the non-dollar currency, and then the first good business day that is common to the currency and New York. The only exception to this convention is USD-CAD which is one Toronto business day, and then the first common business day in Toronto and New York. For an FX option, cash settlement is made in the same manner, with the settlement calculation using the option expiry date as the start of the calculation. The settlement convention affects discounting cash flows and must be considered in the valuation. The FINCAD functions allow the specification of various FX rate market conventions that are able to cover most currency pairs available in the market. Regarding the possible input formats, the users can specify the conventions for the two currencies of the FX rate manually, in a combined or separate manner. For the former, two elements can be taken in as maturity descriptor and holiday convention that are shared for both currencies. For the latter, five elements can be taken in as one set of maturity descriptor and holiday convention for the currency one, another set of similar inputs for the currency two and an additional input of holiday convention. This corresponds to the most generic specification of the settlement convention that can be used for cross rate trades, e.g. a CAD-EUR trade that has settlement dates calculated using New York as well as Toronto and Target holidays.

Analysis Supported

FINCAD FX forward functions can be used for the following:

  • Calculate an FX forward rate and a rate basis of FX forward and spot difference;
  • Calculate fair value and risk report of an FX forward contract with settlement convention.

To learn more about FINCAD FX forward functions, contact a FINCAD Representative

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