Spread – the Difference Between Buying and Selling Price

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A forward exchange contract is an agreement to exchange currencies at a future date at a pre-contracted exchange rate. Forward contracts are written by banks and trade between banks in the interbank market and are entered into with banks’ clients.As with the spot market, the forward market is a decentralized, continuous, open-bid double-auction market. Forward exchange trades in both outright and swap form, where the latter involves the purchase/sale and subsequent sale/purchase of a currency.

What is a foreign premium rate? What is a forward discount rate? How are they affected by expectations of future spot rates and actual changes (expected or unexpected) of spot rates during the duration of a forward contract?

A forward premium on a foreign currency means that the forward value of the foreign currency exceeds the currency’s spot value. A forward discount means the forward value is less than the spot value.The value of a forward transaction is determined at its maturity by the realized spot rate at that time. During its term, a forward contract may have appreciated or depreciated in value which may have been either anticipated or unanticipated.

How does an “outright” forward contract differ from a “swap”?

Swaps, which involve a double exchange—usually a spot exchange subsequently reversed by a forward exchange – are traded between banks so that individual banks can efficiently manage their foreign exchange risk. Swaps are also valuable to international investors and borrowers, whereas outright forwards are valuable to importers and exporters.

What does it mean to be “long” or “short” in a currency?

Being “long” in a currency is agreeing to purchase more of a foreign currency than it has agreed to sell. Being “short” in a currency is agreeing to sell more of a foreign currency than it has agreed to buy.

What is a “non-deliverable forward contract”? Why do non-deliverable forward contracts exist?

These are similar to the traditional form of forward contract in that they specify a contracted exchange rate and future settlement date. However, on the settlement date the foreign currency is not paid for and delivered to the buyer. Rather, the difference between the agreed settlement rate and the current spot rate is paid by the party losing, and received by the party gaining, from the movement in the exchange rate. These types of contract are particularly popular with emerging market currencies where currency delivery is difficult.Non-deliverable forward contracts are made when there are limitations on currency convertibility.

What is the meaning of the “maturity date” on a forward contract?

The date of reverse deal closure is called swap termination or maturity date.

What is the meaning of the “value date” on a forward contract?

A value date is the delivery date of funds traded. For spot transactions it is the future date on which the trade is settled. In the case of a spot foreign exchange trade it is normally two days after a transaction is agreed upon.

Note:

The reason banks quote larger spreads on longer-maturity contracts is not, as some people seem to think, that longer-maturity contracts are riskier to the banks because there is a longer period to maturity during which time spot exchange rates might change. As we have explained, banks tend to balance their forward positions by the use of swaps and rollovers, and since they can buy and sell forward for each maturity, they can avoid losses from changes in exchange rates on forward contracts;whatever a bank gains (loses) on a forward contracts to sell it loses (gains) on an offsetting forward contract to buy. Rather, the reason spreads increase with maturity is the increasing thinness of the forward market as maturity increases. By “increasing thinness” we mean a smaller trading volume of longer-maturity forwards, which in turn means greater difficulty offsetting positions in the interbank forward market after taking orders to buy or sell.

Chapter 4: Currency Futures and Options Markets

What is a currency futures contract?

Currency futures are bets on what will happen to the expected future spot exchange rate, settled every day. Futures are traded in specialized markets in standard contract sizes, such as 125,000. There are relatively few maturity dates.Because of their low transactions costs and easy settlement, currency futures appeal to speculators. The payoff profiles for futures are similar to those for forward contracts, except that futures outcomes are a little uncertain because of marking-to-market risk.

What is the meaning of “open interest”?

The extent to which futures are used to speculate rather than to hedge is indicated, albeit imperfectly, by the statistics on open interest. This refers to the number of outstanding two-sided contracts at any given time. Typically, open interest numbers indicate that most of the activity in currency futures is in the nearest maturity contracts. Open interest also falls off substantially just prior to maturity, with delivery rarely being taken.

What is the meaning of “margin” on a futures contract?

Margins are financial guarantees required of both buyers and sellers of futures contracts to ensure that they fulfill their futures contract obligations. Before a futures position can be opened, there must be enough available balance in the futures trader's margin account to meet the initial margin requirement. Upon opening the futures position, an amount equal to the initial margin requirement will be deducted from the trader's margin account and transferred to the exchange's clearing firm, where it will be held as long as the futures position remains open.

What is a meant by a margin’s “maintenance level”?

The maintenance margin is the minimum amount a futures trader is required to maintain in his margin account in order to hold a futures position. The maintenance margin level is usually slightly below the initial margin.

If the balance in the futures trader's margin account falls below the maintenance margin level, he or she will receive a margin call to top up his margin account so as to meet the initial margin requirement.

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