Can someone who understands currency markets explain this to me. I was looking at my Thai bank's exchange rates and I noticed a tab that said "Forward Exchange Rates". The screen capture below is what I got when I selected it.
It doesn't make much sense as some rates are very low or even negative whereas (for the dollar for instance) the rate six months out looks pretty good.
How does this work? (click on it and it will enlarge the screen capture to a size where it is readable)
My brain is like an Internet browser; 12 tabs are open and 5 of them are not responding, there's a GIF playing in an endless loop,... and where is that annoying music coming from?
It's a means of agreeing a price for trading currency in the future but the agreement is arranged 'today'.
The figures you see are derived from the current exchange rate , the interest rates of both currencies and the number of months between today and the agreement execution date.
FX Forward rates are the number of points between todays exchange rate and the projected exchange rate for whatever time in the future.
An example calculation for USD/THB would be (simplified to use bank base rates interest not monthly LIBOR rates).
USD/THB = 30.2398
USD Int = 0.25%
THB Int = 2.75%
Execution Date = +6 Months (usually shown as 180/360)
(30.2398*((1 + 0.0025)^(180/360)))/((1 + 0.0275)^(180/360)) = 29.8696
The difference in points is 30.2398-29.8696 = 0.3702
Your image shows your bank giving bid/ask as 34/41 - the difference between the two is their 'spread' or basically the money they charge you to execute the trade, the longer the trade the higher the spread usually is (to hedge against losses).
It's difficult to give a simple AND accurate example of using a forward rate trade so this is just 'simple';
Lets say you need 100,000 EUR in six months time.
At the moment 100,000 EUR will cost you approximately 4.3 million THB.
You have a couple of options.
1. You wait six months and take the prevailing rate
Simple enough but leaves you open to market fluctuations, THB might weaken against EUR costing you much more, or it might strengthen costing you much less, either way you don't know how much it's going to cost until the day you execute the trade.
2. You make a forward trade agreement using the forward rate.
This means you agree to pay, say, 4.2 million THB in six months time.
Main advantage is that even if rates climb and it costs 4.5 million THB in six months to buy 100,000 EUR, you only need to pay 4.2m.
Main disadvantage is that if rates drop and you only need 4.0 million THB to buy 100,000 EUR you still need to pay 4.2m
Either way you know exactly how much it's going to cost regardless of currency fluctuations.
Notice that in your image that the countries with negative forward rates have higher interest rates than BOT/THB (AUD being the highest, NZD being the next and so on down to the countries with very low interest rates GBP, USD, JPY) The numbers don't follow precisely due to the differences between the quoted currencies but USD/AUD are close to parity but with vastly different interest rates, USD/CAD are close to parity and both have low interest rates.
While it looks like a method of hedging for FX traders I don't think it really is, it's a means of knowing in your local currency how much you have to pay for a non-domestic service in the future. Obviously if you are considering a trade, to buy a non-domestic service/asset using the banks FX Fwd facilities you really must get paid advice from a professional who understands FX Fwd inside out, there are a huge number of variables involved in the FX markets, interest rates are not the only drivers but it takes away the risk aspect of waiting.
Thank you very much for that good and easily understandable explanation. I actually looked it up on Wiki before posting and it still didn't make sense but your explanation does!
My brain is like an Internet browser; 12 tabs are open and 5 of them are not responding, there's a GIF playing in an endless loop,... and where is that annoying music coming from?
