Synthetic agreements for forward exchange (SAFEs) are a type of hedging instrument that can be used to fix the exchange rate between two currencies for a specified future period. They are similar to forward contracts, except that no actual currency is delivered at maturity. Instead, the difference between the agreed rate and the prevailing spot rate is settled in US dollars between the two parties. This way, the risk of exchange rate fluctuations is reduced, and the need for counterparties or delivery requirements is eliminated.
SAFEs are often used in markets where forward FX trading is banned or restricted, such as Brazil, India, China, and Russia. These are some of the fastest growing economies in the world, and their currencies are subject to high volatility and capital controls. By using SAFEs, investors and traders can gain exposure to these markets without violating the local regulations or facing delivery issues.
To create a synthetic long forward contract on a currency pair, an investor can buy a call option and sell a put option with the same strike price and expiration date. This mimics the payoff of a regular forward contract, where the investor agrees to buy the currency at a fixed rate in the future. The net option premium paid or received by the investor depends on the relative prices of the call and put options, which reflect the interest rate differentials and the expectations of the market participants.
For example, suppose an investor wants to buy Brazilian reals (BRL) and sell US dollars (USD) in three months, and the current spot rate is 1.6983 BRL/USD. The investor can enter into a SAFE by buying a call option and selling a put option with a strike price of 1.7000 BRL/USD and an expiration date in three months. If the spot rate in three months is higher than 1.7000, the investor will exercise the call option and buy BRL at 1.7000. If the spot rate is lower than 1.7000, the investor will be assigned the put option and buy BRL at 1.7000. In either case, the investor will receive the difference between the spot rate and the strike price in USD, which will offset the cost or benefit of buying BRL at the fixed rate.
Basic Theory
A forward exchange contract allows parties to lock in a future exchange rate for a specified amount of currency. However, synthetic agreements provide an alternative method to achieve a similar outcome without directly entering into a forward contract. Instead, a combination of spot transactions and money market investments is used to replicate the cash flows associated with a forward contract.
Procedures
- Identify the Underlying Forward ContractDetermine the characteristics of the desired forward contract, including the currencies involved, the amount, and the maturity date.
- Execute Spot TransactionsPerform spot transactions to buy or sell the required amount of currency at the current spot exchange rate.
- Invest or Borrow FundsInvest or borrow funds in the respective money markets to achieve the desired future cash flow.
- Monitor and AdjustRegularly monitor the positions and adjust the investment or borrowing strategy to ensure alignment with the forward contract’s economic effect.
Explanation
Let’s consider a scenario where Company XYZ, a U.S.-based exporter, expects to receive €100,000 in three months from a European customer. The current spot exchange rate is 1.10 USD/EUR, and Company XYZ wants to lock in a forward rate to protect against potential currency depreciation.
Scenario
- Amount to be received: €100,000
- Spot exchange rate: 1.10 USD/EUR
- Forward exchange rate (desired): 1.12 USD/EUR
- Maturity: 3 months
Excel Calculation
- Execute Spot Transaction:Purchase €100,000 at the spot rate:
=100,000*1.10= $110,000 - Invest Funds:Invest the purchased amount in a U.S. money market instrument offering an interest rate of 2% annually for three months. Use the formula:
=FV(2%/4,3,-110000)to calculate the future value. - Calculate Forward Rate:Determine the forward rate that would make the investment result in the desired future value. Use the formula:
=110000/FV(2%/4,3)to find the equivalent forward rate. - Adjustments:Monitor the exchange rates and adjust the investment or borrowing strategy as needed.
Result
After executing the above steps, Company XYZ effectively created a synthetic forward agreement, achieving the economic outcome of locking in a forward exchange rate for €100,000 in three months.
Other Approaches
Option-Based Synthetic Agreements
Another approach involves using currency options to achieve a similar economic effect. By purchasing call or put options, a company can create a synthetic forward position while maintaining the flexibility to decide whether to exercise the option.
Money Market Hedge
In addition to the synthetic agreements discussed, a money market hedge involves investing or borrowing funds in the money market to offset the currency risk. This approach requires careful consideration of interest rates and exchange rate movements.
