Mini Chapter Six

Foreign Exchange & Interest Rate

Spot and Forward

Spot denotes the price of currency A in terms of currency B settled typically T+2. Any contract with non-standard settlement (that’s generally not Spot) is termed as an outright forward. Difference between outright forwards and spot denotes the premium/discount on currency A in terms of currency B, termed as FX points. Or the other way as in the real world – FX forwards are generated by adding FX points to Spot. In a zero arbitrage world that adheres to interest rate parity, forward points should be an exact reflection of the ratio of the FX-implied local currency zero rate and the benchmark/foreign currency zero rate. Effectively if one borrowed in one currency (paying that currency’s interest rate for borrowing) and invested the proceeds in the other currency (earning the other currency’s interest rate) then the forward points should neutralise any net gains.

$ K R W_{f o r w o r d (t)} = $ K R W_{s p o t} \times \frac{(1 + R_{K R W} \times \frac{t}{365})}{(​ 1 + R_{U S D} \times \frac{t}{365})}

\frac{U S D}{K R W} f o r w o r d (t) = \frac{U S D}{K R W_{s p o t}} \times \frac{(1 + R_{K R W} \times \frac{t}{365})}{(​ 1 + R_{U S D} \times \frac{t}{365})}

Where t = tenor of the forward expressed in days,
R_KRW and R_USD are the respective annual interest rates for tenor t

The above trade can be deconstructed into individual cash flows as below (assuming we buy $KRW spot and sell $KRW forward):

- Buy $KRW at spot rate at time t₀

- Lend USD to earn the below in time t

U S D \times (1 + R_{U S D} \times \frac{t}{365})

- Borrow KRW and pay the cost in time t as below

K R W \times (1 + R_{K R W} \times \frac{t}{365})

- Sell USD

\times (1 + R_{U S D} \times \frac{t}{365})

against buy KRW

\times (1 + R_{K R W} \times \frac{t}{365})

which implies selling in the forward leg.

If the $KRW Forward rate as implied by the notional values in the last bullet is different from the $KRW formula denoted above one could arbitrage the above cash flows against the forward rate for a net gain.

If the

\frac{U S D}{K R W}

Forward rate as implied by the notional values in the last bullet is different from the

\frac{U S D}{K R W}

formula denoted above one could arbitrage the above cash flows against the forward rate for a net gain.

The local currency interest rate as derived from the above formula is termed as Implied FX interest rate (different from the actual local currency deposit or risk free rate).

Spot + FX forward transaction is effectively borrowing in one currency against lending in the other currency at their respective interest rates and FX forward points are thus a reflection of the respective interest rate differentials.

In reality however interest rate parity isn’t met due to the following reasons:

1. Limited capacity of counterparties to borrow and/or lend in each of the individual currencies at their respective benchmark rates given balance sheet/credit constraints
2. Bid-offers on borrowing vs lending of currencies
3. Limits on products such as FX forwards imposed by central banks
4. Demand and supply for foreign exchange hedging

Synthetic Borrowing using FX Forwards – An example of how local counterparties use FX Forward market to borrow hard currency is discussed below:

Korean Counterparty does a Buy/Sell $ KRW FX Swap with a bank in Korea. Effectively it has bought USD against KRW for the near date and sold USD against KRW for the far date i.e. USD has been borrowed and KRW has been lent. Large flows of this nature will create a disparity leading to forward points being different (lower in this case) from what should be denoted by the actual yield differential / Interest Rate parity. Countries with large dollar-denominated investments of local asset managers (Korea, Japan, Taiwan typical cases) exhibit this behaviour.

In other words – the return on KRW funds to generate USD is lower than the local KRW interest rate or the cost of borrowing USD using KRW cash is higher than the benchmark USD interest rate.

Deliverable and Non-deliverable forwards

Currencies subject to restrictions on capital account convertibility have forward contracts that are non-deliverable i.e. they do not involve notional exchange and are net-cash settled at the end of the contract. The net cash is typically exchanged in the base/hard currency (eg USD or EUR) depending on the contract.

N e t c a s h s e t t l e m e n t = U S D N o t i o n a l \times \frac{(K - F X_{f i x})}{F X_{f i x}}

K = forward contract strike
FX_fix = FX as of settlement date at the relevant published fixing rate (proxy for spot on maturity of the contract)

Deliverable FX forwards (onshore) and non-deliverable forwards (offshore) are economically (i.e. in terms of P&L) the same though settlement cash flows are different. For instance a deliverable 3 month USDINR outright forward at 85 would make the same P&L (hold the same value) as a non-deliverable forward contract at 85 on maturity as long as the FX_fix is a good proxy for the spot rate at maturity.

Currencies like SGD, HKD and THB trade on a deliverable basis even in the offshore markets.

In Asia NDF markets exist for currencies like INR, IDR, KRW, CNY, TWD, PHP as an offshore expression of the currency view. In addition for China there is a deliverable unit namely CNH meant for offshore usage that closely tracks onshore RMB oftentimes with a steady basis owing to the varying demand for CNH relative to RMB.

Activity in forward markets comprises hedging, receivables, financing, and speculative flows.

Deliverable NDF (Onshore NDF)

In recent times there’s been an emergence of an NDF market onshore (eg. Indonesia) as BI felt the need for exerting more control over its FX markets while catering to the hedging needs of investors. The D-NDF market is typically used to hedge actual onshore investments as compared to offshore NDFs which do not require underlying exposure. Also Indonesia being an indexed market has boasted of sizeable offshore bond ownership, hence the supply of FX forwards (potential hedges) in the D-NDF market has helped contain panic in times of broader EM risk-off.

Again as stated above – from an economic perspective the D-NDF and NDF contracts are economically same and should price at the same level – but there exists supply demand dynamics which can cause differences to emerge between the two.

The D-NDF market typically settles the contract using the local currency while an NDF contract offshore settles in hard currency (eg USD).

Mini Chapter Six

Foreign Exchange & Interest Rate

Spot and Forward

Deliverable and Non-deliverable forwards

Deliverable NDF (Onshore NDF)

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Related Resources

Time Value of Money

1: Time Value of Money & Power of Compounding

2: Bootstrapping of Yield Curves – Par, Zero, Forward

3: Duration & Convexity

4: Duration and PVBP for a Floating Rate Bond

5: Money Market and Cash Bonds

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Varda Pandey