Understanding Long-Dated Forwards in Foreign Exchange

A long-dated forward is a type of forward contract that is used to lock in the exchange rate for buying or selling a currency on a future date. A forward contract is an agreement between two parties to exchange an asset at a specified price and time. Unlike futures contracts, which are standardized and traded on exchanges, forward contracts are customized and traded over-the-counter (OTC).

Long-dated forwards have settlement dates that are longer than one year away and can be as far as 10 years. They are often used by companies that need to hedge their currency risk for a long period of time, such as importers, exporters, or investors who have foreign currency exposure. For example, a company that knows it will need to pay 1 million euros in two years can enter into a long-dated forward contract with a bank to buy 1 million euros at a fixed rate of $1.20 per euro. This way, the company can eliminate the uncertainty of future exchange rate fluctuations and budget its cash flow accordingly.

The price of a long-dated forward contract is determined by the interest rate differential between the two currencies involved. The higher the interest rate of the currency being sold, the lower the forward rate, and vice versa. This is because the party that sells the currency with a higher interest rate can invest the proceeds at a higher rate and earn more interest than the party that sells the currency with a lower interest rate. Therefore, the party that sells the higher interest rate currency will accept a lower forward rate as compensation.

Long-dated forwards are riskier than short-dated forwards because of the longer time horizon and the greater uncertainty of future market conditions. The parties involved in a long-dated forward contract face the risk of default by the counterparty, as well as the risk of unfavorable changes in the spot rate. If the spot rate at the time of settlement is more favorable than the forward rate, the party that agreed to buy the currency will lose money, and vice versa. To mitigate these risks, some long-dated forward contracts may require collateral or margin payments from the parties.

Basic Theory:

A forward contract is an agreement between two parties to buy or sell an asset at a future date for a price agreed upon today. Long-dated forwards extend this concept to a more extended period, often beyond one year. The key elements include the agreed-upon exchange rate, the notional amount, and the maturity date.

The formula for the payoff of a long-dated forward contract is:

Where:

• is the size of the contract.
• is the agreed-upon exchange rate in the forward contract.
• is the current exchange rate in the market.

Procedures:

1. Determine the Notional Amount: Decide on the amount of currency you want to exchange in the future.
2. Set the Forward Rate: Agree on the exchange rate for the future transaction. This rate is typically influenced by interest rate differentials between the two currencies.
3. Calculate Spot Rate: Determine the current market exchange rate for the currencies involved.
4. Use Excel Formulas:
   • Payoff Formula:
   • Excel Function: =NotionalAmount * (ForwardRate - SpotRate)

Explanation with Scenario:

Let’s consider a scenario:

• Notional Amount: $1,000,000
• Forward Rate: 1.25 USD/EUR
• Spot Rate: 1.20 USD/EUR

Result:

In this scenario, the payoff from the long-dated forward contract would be $50,000.

Other Approaches:

1. Sensitivity Analysis: Assess the impact of changes in exchange rates on the payoff by altering the spot rate.
2. Monte Carlo Simulation: Use Excel’s random number functions to simulate multiple scenarios, providing a range of potential outcomes.
3. Scenario Analysis: Create different scenarios with varying notional amounts and forward rates to analyze the impact on payoff under different conditions.