Understanding Foreign Exchange Agreements in Excel Formulas

A foreign exchange agreement is a legal arrangement between two parties where money is exchanged internationally at a certain exchange rate. This agreement ensures that both parties understand how much money is being exchanged, what the exchange rate is, and when the exchange will take place. This type of agreement is most commonly used when an organization wishes to buy merchandise from a foreign supplier, but wants to protect themselves against paying more due to fluctuations in exchange rates. In other words, the foreign exchange agreement locks in the price. When there are expected changes in exchange rates, some people, called speculators, use these agreements to make a profit.

There are different types of foreign exchange agreements, depending on the nature and timing of the transactions. For example, a spot contract is an agreement to exchange currency at the current market rate, usually within two business days. A forward contract is an agreement to exchange currency at a fixed rate in the future, usually more than two business days. An option contract is an agreement that gives the buyer the right, but not the obligation, to exchange currency at a specified rate on or before a certain date. A swap contract is an agreement to exchange currency at one rate and then reverse the exchange at a different rate in the future.

Foreign exchange agreements are governed by standardized master agreements that set out the terms and conditions of all such transactions between the parties. These master agreements also explain the consequences of default, force majeure, or other unforeseen circumstances. One of the most widely used master agreements is the International Foreign Exchange Master Agreement (IFEMA), which covers spot and forward transactions in the foreign exchange market2. Other master agreements include ICOM, for International Currency Market Options, and FEOMA, the Foreign Exchange and Options Master Agreement, which combines the IFEMA and ICOM agreements and covers spot and forward foreign exchange transactions and currency options.

Basic Theory:

Foreign exchange agreements involve the simultaneous purchase and sale of a specified amount of one currency for another with an agreed-upon exchange rate. These transactions are conducted at the current spot rate, with a commitment to reverse the transaction at a future date, typically referred to as the maturity date. The difference between the spot rate and the forward rate reflects the interest rate differential between the two currencies for the specified period.

Procedures:

Determine the Terms: Decide on the currencies involved, the notional amount, the spot exchange rate, and the maturity date.
Calculate the Forward Rate: Use the interest rate differential to determine the forward exchange rate.
Execute the Swap: Exchange the agreed-upon currencies at the spot rate.
Hold Until Maturity: Hold the currencies until the maturity date.
Reverse the Swap: Exchange the currencies back at the previously agreed-upon forward rate.

Excel Formulas:

Let’s consider a scenario where Company A, based in the United States, wants to hedge against currency risk by entering into an FX swap with Company B, based in the Eurozone.

Assuming:

Notional amount: $1,000,000
Spot exchange rate (EUR/USD): 1.12
Interest rate in the US: 2%
Interest rate in the Eurozone: 1.5%
Maturity: 3 months

Scenario:

1. Calculate the Forward Rate:

$\text{Forward Rate} = \text{Spot Rate} \times \left(1 + \frac{\text{Interest Rate in the US}}{100} \times \frac{\text{Maturity}}{12}\right) \div \left(1 + \frac{\text{Interest Rate in the Eurozone}}{100} \times \frac{\text{Maturity}}{12}\right)$

$\text{Forward Rate} \approx 1.12203$

2. Calculate the Initial Dollar Payment (USD to EUR):

$\text{Initial Payment} = \text{Notional Amount} \times \text{Spot Rate}$

$\text{Initial Payment} = $1,000,000 \times 1.12$

$\text{Initial Payment} = $1,120,000$

3. Calculate the Future Value (EUR to USD):

$\text{Future Value} = \text{Notional Amount} \times \text{Forward Rate}$

$\text{Future Value} \approx $1,122,030$

4. Result:

Company A initially pays $1,120,000, and after three months, it receives approximately $1,122,030, effectively hedging against potential currency depreciation.

Other Approaches:

Using Excel Functions: Excel provides functions like FV (Future Value) and PV (Present Value) that can simplify calculations.
Scenario Analysis: Perform sensitivity analysis by changing variables (e.g., interest rates, maturity) to understand the impact on the hedging outcome.