Spot & Forward

The advantage to Spot & Forward Deals

In foreign exchange trading, there are two main contracts that are used: Spot deals & Forward deals.
The main difference between the two is the timing and the purpose of use.
» Spot deals: Spot deals are of daily nature and handle only with the current market, meaning a contract for immediate delivery in the current rate of exchange. The  spot rate of exchange refers to the rate at which foreign currency is available on the spot, representing the price that a buyer expects to pay for a foreign currency in another currency. 
Spot deals do not charge interest rate differences for deals taken for up until 2 days. 
This makes spot deals more attractive to speculators taking intraday traders.
*  After 2 days, if you wish to continue with the trade, you need to roll the position unless your broker does it automatically. Once the time-frame is exceeded, the position will charge interest, either in your advantage or as an expense. 
» Forward deals: A forward deal is a deal in which foreign exchange is bought and sold for future delivery. It deals with transactions, mainly of foreign exchange buyers and sellers, which are contracted today but implemented sometimes in future. 
The clear advantage of forwards deals is that it enables you to avoid the risk of currency fluctuations. This is called currency hedging. They are mainly used by importers / exporters, retailers and financial institutions.
Forward deals are available for 3 months, 6 months, 9 months, a year and even for 2 years.
The forward deal allows you to lock the current spot rate in order to minimize the risk of loss due to adverse change in exchange rates and still make a profit.
In addition, you can profit from the interest differences between the currencies when you hold (buy) the currency that has a higher interest and sell the currency whose interest is lower, even if the exchange rates between the currencies haven’t changed during that period.
Example: A big importer of American cars in Europe wants to import 1,000 new model cars in order to sell them in Europe. For each car he owes €30,000 (=total €30,000,000). 
The exchange rate of the EUR/USD at that moment is 1.2000 and he fears that by the time the shipment arrives, 6 months from now, the exchange rate will go up to 1.4000. Therefore, he prefers locking the current rate of 1.2000.
* He can’t pay upfront because he hasn’t sold the cars yet and can’t risk hurting the company’s cashflow. 
* He therefore opens a forward deal with a prime broker / bank, paying 10% upfront (margin), and a leverage of 10% (€3,000,000).
* He adds 10% to the selling price of the ordered cars in order to cover his forward deal’s payment. The selling price of each car is therefore €33,000. (It is actually the client who is financing the transaction).
Scenario:
a.   If during the 6 months the exchange rate will drop more than 10% (the EURO will weaken more than 10%), the importer will have no damages because the price of the forward deal was already calculated into the selling price of each car.
b.  If during the 6 months the exchange rate will indeed rise to 1.4000 (almost 15%), the importer is protected thanks to the coverage he took with the prime broker / bank. In this scenario, the importer actually made profits and the prime broker / bank will have to give him the surplus with which he can pay the difference.

 

Forward deal’s formula:

FWD = Forward rate
Spot = The current spot rate of the market
Period = The duration of the forward deal
R1 = The interest of the first currency      (for the period of the deal)
R2 = The interest of the second currency (for the period of the deal)
Example: Say we are interested in buying €100,000 in order to profit from its strengthening against the $, for a period of 6 months. 
After checking, we know that:
* The current spot rate of the currency is 1.4310.
* The EURO’s interest rate is 1.11% (R1) for 6 months (Period).
* The interest rate of the USD is 2.115$ (R2) for 6 months (Period).

We have found that the forward deal today for a 6 months period of buying the EURO against the USD will be settled at the rate of 1.4167, a  lower rate than the current spot rate of the currency, which is a better entry rate.
Even if the currency rates do not change during the 6 months period, we have a profit of 143 pips.