Synthetic Forwards

Forward contracts are a commonly used technique to hedge foreign exchange risk. However, some governments have banned forward FX trading - usually as a means to reduce exchange rate volatility.

For example:

• Brazilian Reals.
• Philippine Peso.
• Indian Rupee.
• Taiwan Dollars.
• Korean Won.
• Russian Ruble.
• Chinese Renminbi (or Yuan)

This is particulary significant given that all four of the fastest growing economies in the world - Brazil, Russia, India and China (the so-called 'BRIC' economies) - are included here.

 In such markets the use of non-deliverable forwards (NDFs) has developed. In effect these work like forward contracts where forward contracts are banned.

Synthetic foreign exchange agreements (SAFEs)

These are like forward contracts, except no currency is delivered. Instead the profit or loss (i.e. the difference between actual and NDF rates) on a notional amount of currency (the face value of the NDF) is settled between the two counter parties.

Combined with an actual currency exchange at the prevailing spot rate, this effectively fixes the future rate in a similar manner to futures.

One other feature is that the settlement is in US dollars.

Illustration

Let the spot rate between the US$ and the Brazilian Real be 1.6983 Reals to $1 and suppose we agree a 3 month NDF to buy $1 million worth of Reals at 1.7000.

If the spot rate moves to 1.6800 in 3 months, then the counter-party will have to pay us 1million × 0.02 = 20,000 Reals.

This will be settled in US$, so the actual receipt will be 20,000/1.6800 = $11,905 

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags:	Forward contracts;synthetic forwards;sythentic foreign exchange agreements;SAFEs;non-deliverable forwards;NDFs