Managing Foreign Exchange Risk through Outrights

Managing Foreign Exchange Risk through Outrights

06 Jun 2020 03:59 PM
 

What are outrights?

Outrights, in FX markets refer to the type of transactions where two parties agree to buy or sell a given amount of currency at a predetermined rate, on  a specified date in future. In simple terms, companies that buy goods and services overseas in different currencies can use this tool to lock in favorable exchange rates.

There are two types of outrights- Forward FX Outrights and Futures FX Outrights. A forward outright is a private agreement that can be customized. It settles at the end of the agreement and is traded over the counter (OTC). A futures outright has standardized terms and is traded on an exchange, where prices are settled on a daily basis (mark-to-market) until the end of the contract.

Here, our main focus will be Forward Outrights because in the FX market, it is easier to trade forwards as they are customized contracts.

For outright positions, both the potential gain and the potential risk are greater than the positions that are covered or hedged using some other strategy. We can say that, an outright position is one which stands on its own, and is not part of a larger or more complex trade.

Forward Outright Transaction: How does it work?

Initiation: A forward outright transaction can be performed within the scope of a financial markets client agreement. The inputs of the contract- the currency pair, exchange rate and the value date of making real entries- are agreed on the day the transaction is made.

Pricing: The forward rate, which is the price of a forward outright, is calculated by adding to or deducting from the spot rate the “forward points” arising from the difference in interest rates between the respective currencies. Thus, the forward points reflect interest rate differentials between two currencies. Effectively, the lower yielding currency will trade at a premium going forward and vice versa.

Settlement: An outright forward is an obligation to take delivery of the purchased currency and make delivery of the currency that was sold. Instructions must be provided by the counterparties as to the specific accounts where the delivery of currencies is to be taken. The delivery is made two working days ahead of the maturity date.

An outright forward can be closed out by entering into a new contract with an opposite position which can result in either a gain or loss versus the original position, depending on market movements. If the new contract is entered into with the same counterparty as the original contract, the currency amounts are usually netted under an International Swap Dealers Association agreement. This reduces the settlement risk and the amount of money that needs to change hands.

When to use it?

  • Exporters:-

WHEN?

The market outlook is bearish for the foreign currency. The exporter believes that rupee is going to appreciate against the foreign currency. To hedge his loss, he can sell a forward outright and book a favorable exchange rate for the future date.

On the settlement day, the exporter is effectively buying rupee and selling the foreign currency

  • Potential gain: Unlimited, profits increase as forward rate rises
  • Potential loss: Unlimited, losses increase as forward rate falls

 

  • Importers:-

WHEN?

The market outlook is bullish for the foreign currency. The importer believes that the rupee is going to depreciate against the foreign currency. To hedge his loss, he can buy a forward outright and book a favorable exchange rate for the future date.

On the settlement day, the importer is effectively buying the foreign currency and selling the rupee

  • Potential gain: Unlimited, profits increase as forward rate falls
  • Potential loss: Unlimited, losses increase as forward rate rises

Note: Changes in implied volatility have no effect on this position. Traders having a point of view on volatility may consider some other strategy. Another strategy may reduce potential losses and/or increase potential profits.

Advantages of using Outrights:

Outrights have proved to be an effective way to manage currency risk when one is exposed to foreign exchange rates. It hedges by fixing an exchange rate for future delivery date which stabilizes the uncertain position of the trader.

Also, there are no upfront costs for hedging using outrights. The cost of an outright is the difference between spot rate on maturity and the outright rate (forward rate) i.e. the premium. No money changes hands between the two parties at the initiation of the contract.

Things to watch!

An Outright rate differs from the rate used in spot market, which is the price that the currency picks up today. The difference occurs because the outright rate factors in characteristics such as volatility of currencies and their mutual opinion of where they think the exchange rate will be in the future.

Therefore, the exchange rate can move in the direction which would have been favorable, had the hedge not been implemented. In such a case, the hedged trader is not able to gain from the favorable movement in the exchange rate because the rate has been determined and it is a binding obligation which cannot be withdrawn from.

Appropriate advice from forex experts has proved to be more beneficial than just speculating the currency movements and hedging based on them. Myforexeye provides a combination of many services related to foreign exchange. Currency trading with guidance from forex experts and specific forex risk advisory services are some of the services which help the trader to make suitable hedges while aiming to prevent losses through FX outrights. Their state of the art dealing room helps in tracking the open trades and also smooth execution helps in achieving the desired outcome.

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