Mechanics of FX Forwards
Financial institutions screen potential buyers of FX forward contracts to protect themselves from counterparty default risk. Different institutions have different screening methods, but all methods try to measure the creditworthiness of the client. This involves analysis of the potential client’s current and historical financial position and credit history. It is worth noting that financial institutions often already have an ongoing relationship with the FX forward client. A potential client must also demonstrate sufficient understanding of the FX market. The financial institution also considers the stated purpose for buying an FX forward. Clients must have economic basis for buying the forward, such as to hedge a specific foreign exchange risk exposure. Speculation is usually discouraged. A minimum principal size might also be specified by contract writers and a maximum principal size by regulators.
Once a client has been successfully screened for purpose, expertise and creditworthiness, an over-the-counter forward is structured to the specific needs of the client. The most basic components of maturity, principal and currency pair are specified first. In order to structure an effective hedge, these components must be matched to the FX risk exposure that the client faces. The principal is determined by considering the amount of exposure. FX risk exposure can be an exact amount (such as when a client has a fixed expense in the future) or an estimated amount (such as when future cash flows are uncertain). It is also important to match the timing of expected obligations. There are four relevant dates that must be specified, these are:
1. Contract date – the date that the terms of a contract are accepted by either party 2. Fixing date – the date that the forward rates are calculated for the FX forward 3. Maturity date – the date that the contract matures
4. Settlement date – the date...
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