When an investor enters into a transaction to purchase a currency they are, by implication, also entering into a transaction to sell a different currency, as currencies always trade in pairs. Said another way, if an investor were to purchase Australian dollars (AUD) using U.S. dollars (USD), that investor would be selling USD to purchase AUD.
A common method of purchasing currencies is through the spot market. In the spot market, a buyer and seller agree to transact at a specified price, usually with trade settlement (delivery of the purchased currency) within one or two days. The trade is typically facilitated through a market maker or broker, in much the same way one buys or sells stocks. Another method of purchasing currencies is through the use of forward contracts – a topic I will discuss in an upcoming Currencies Unplugged.
Unlike selling short a stock, an investor can contract to sell a currency at a future date without using any leverage. This is because you don’t need to physically borrow a stock off another investor with the intention of paying for it at some future point in time. Rather, through a forward currency contract, an investor can enter into an agreement to sell a currency for a predetermined price on a specified future date.
By contracting to sell one currency, an investor is, by implication, also contracting to purchase another currency, as currencies always trade in pairs. By way of example, if an investor entered into a contract to purchase Australian dollars (AUD) by selling U.S. dollars (USD), this transaction in itself would create a net short USD position and a net long AUD position. Conversely, if the fund were to enter into a contract to purchase USD by selling AUD, this transaction itself would create a net long USD position and a net short AUD position.
The process to purchase a currency through a spot currency contract is no different than buying a security, say, for instance, IBM, on an exchange. When you buy shares of IBM, you agree to pay a certain amount of U.S. dollars for an agreed upon number of shares today, and the transaction is typically settled in three business days (i.e. you transfer the funds and receive the shares three business days from today). Similarly, when you buy a currency you can enter into a spot currency contract today, where you agree to pay a certain amount of U.S. dollars in exchange for an agreed amount of currency, with settlement of the trade typically in two business days (i.e. you pay for the currency and take delivery of the currency in two business days).
A forward currency contract is similar to a spot currency contract except for one important distinction: it can be customized to settle (i.e. pay for and take delivery of the currency) at any specified time in the future. A purchaser of a currency may enter into a forward currency contract where they agree to pay a certain amount of U.S. dollars in exchange for an agreed amount of currency at any agreed upon future point in time. This allows a purchaser or seller of a currency to tailor the transaction to suit their specific needs.
Both the Merk Absolute Return and Merk Asian Currency Funds have historically gained currency exposure through the use of forward currency contracts; the net notional U.S. dollar value of these contracts is typically fully collateralized.
The counterparty risk on a forward currency contract is the risk that the counterparty fails to meet their obligations. The counterparty on a forward currency contract is generally a large bank with international operations. Because typically no money changes hands at the outset of a forward currency contract, the counterparty risk is limited to the profit or loss on the contract; it is not the notional value of the contract. Counterparty risk may be best illustrated in an example:
Assume an investor enters into a forward currency contract today to purchase 1 million Australian dollars (AUD) at an exchange rate of 0.9000 in one month’s time. Assume also that in one month the AUD appreciates 1% to 0.9090. In one month the investor is obligated to purchase AUD at 0.9000 (and the counterparty is obligated to sell AUD at this rate). The investor can then sell AUD at 0.9090, pocketing the difference ($909,000 – $900,000 = $9,000). This profit is also the extent of the counterparty risk as, should the counterparty fail to sell AUD at 0.9000, since no money changed hands at the outset of the contract, the investor’s $9,000 profit is at risk.
Note, should the above example result in a loss (if the AUD declines in value over this timeframe), the counterparty in this transaction bears the counterparty risk that the investor does not purchase AUD at the contracted higher rate.
If multiple forward currency contracts are open with the same counterparty, the counterparty risk is typically the net profit (loss) of all open positions.
At times, especially for leveraged transactions, collateral may be posted.
When an investor enters into a forward currency contract they are generally quoted forward points. Forward points are added or subtracted to the spot rate and are determined by prevailing interest rates in the two currencies (remember: currencies always trade in pairs) and the length of the contract. Typically, the higher yielding currency has negative points, while the lower yielding currency has positive points. That is to say that if a currency has a relatively higher yield then it will typically cost less in the forward market, if a currency has a relatively lower yield it will typically cost more in the forward market. If this did not hold true, an arbitrage situation may be presented, which in itself could drive prices to equilibrium.
Forward points are commonly quoted in fractions of 1/10,000; +20 points would mean add 0.002 to the spot rate. As an example, if an investor wished to purchase Australian dollars (AUD) using a forward currency contract, and was quoted AUD at 0.9000 minus 55.55 points, the forward rate would be 0.894445.
Currencies are always quoted as how much one unit of one currency (base currency) costs in another currency (quote currency). The most commonly used pricing convention ranks base currencies in the following order of priority: euro (EUR), British pound (GBP), Australian dollar (AUD), New Zealand dollar (NZD), U.S. dollar (USD), all other currencies. Lets take two commonly quoted currencies: the euro and the Japanese yen (JPY). Taking the above pricing convention order of priority, relative to the USD, the price quotes would be as follows: EUR/USD and USD/JPY. In plain English, this translates to: “how many U.S. dollars buys one euro” and “how many Japanese yen buys one U.S dollar”.
This may help to explain why, when the quoted price of the Japanese yen (vs. USD) moves from 90 to 95, the yen actually declines in value – because it now costs more yen to purchase one U.S. dollar (a stronger USD). Conversely, when the quoted price of the euro (vs. USD) moves from 1.40 to 1.45, this would represent a stronger euro, as it now costs more U.S. dollars to purchase one euro (a weaker USD).
Non-convertible currencies, as the name implies, are currencies that cannot be readily exchanged for another currency, generally as a result of government restrictions. The Chinese yuan (CNY) is a well known non-convertible currency. The Chinese authorities do not allow convertibility, in part, as a means to facilitate the managed exchange rate of the yuan (the currency peg).
Non-convertible currencies are not freely traded in the traditional spot or forward currency markets. Rather, investors can replicate an investment in a non-convertible currency using non-deliverable forward (NDF) contracts. An NDF acts like a forward contract for non-convertible currencies, allowing investors to gain exposure to currencies they otherwise would not be able to invest in. Rather than delivering the underlying currency at expiration (as may be the case in a traditional forward currency contract), any profit or loss is settled by making a net payment in a convertible currency, such as the U.S. dollar (USD).
The notional value of a forward currency contract is the underlying amount that an investor has contracted to buy and sell (currencies always trade in pairs – by implication, when an investor contracts to buy one currency, they also contract to sell another currency). For example, an investor might enter into a contract to purchase 1 million Australian dollars (AUD) with U.S. dollars (USD) in one month’s time, at an exchange rate of 0.9000. The notional value for this contract in USD terms is therefore $900,000.
Importantly, though the notional value may be a large sum, there is often no initial outlay required to enter into such a contract. As such, an investor is free to deploy funds into various investments until the value date of the contract.
If an investor has an amount invested in assets such as cash, bonds or stocks that is equivalent to, or exceeds, the total net notional value of all forward currency contracts outstanding, that investor is deemed to have fully collateralized the notional value of their forward currency contracts with said investments.
The main difference is that futures are standardized and traded on a public exchange, whereas forwards can be tailored to meet the specific requirements of the purchaser or seller and are not traded on an exchange.
The standardization of futures contracts generally refers to the expiration date and the contracted amount. For example, euro (EUR) futures contracts are available with quarterly expiration dates: the months of March, June, September and December, while the contract size of each euro future is 125,000 EUR. On the other hand, forward currency contracts are not restricted by size or value date, and therefore oftentimes can meet the needs of investors more precisely.
Additionally, investors have to pay for the futures contract and may need to post certain margin requirements; whereas there is often no initial outlay needed for a forward currency contract, as in many cases collateral is not required. As such, an investor using forward currency contracts may be free to deploy funds into various investments until the value date of the contract.