Foreign Exchange

FX Forward:

1. Definition: The transaction is buying or selling of foreign currency notional in future date.
2. Description: The notional is exchanged between two counterparties in difference currency at pre-determined rate in the future which can be any tenor 1W to 10Y or beyond.
3. Example: MXN vs USD- Buying USD and selling MXN currencies on 1Year completion
4. Trade Information:
   1. Trade Date -> 9/8/21
   1. Settlement/Maturity Date-> 9/8/22
   1. Currency Pair -> MXN/USD
   1. Trade Price-> 30 MXN for 1 USD
   1. Notional USD -> 1MM
   1. Notional MXN -> 30MM
   1. Counterparty -> XYZ Bank
5. Link
6. Market Data
   1. MXN vs USD FX spot rate
   1. MXN vs USD FX Forward points curve.
   1. USD Discount factors.
7. Model Valuation and Risk

After 2 Months

Once we have market data how to use the market date calculate the NPV (Net Present Value) and Risks.

We need:

1. Spot Rate:MXN vs USD FX spot rate.
2. Fwd Pts: Using Quant Tool, calibrate the MXN vs USD FX Forward points. We can interpolate the calibrated the curve to determine what is the exact forward point to this 1YR trade.
3. USD DF :USD Discount factor calibration to get the DF for the 9/8/22.

In remaining 10 months:

FX spot rate -> 25

Fwd Point -> 10 ( maturing on 9/8/22)

USD DF -> .98 ( on 9/8/22)

New Price for the trade will be = FX spot rate + Fwd Point = 25 + 10 = 35

Now convert 30MM MXN into USD using 35 MXN price  => 857,142.86 USD

As per the contract we receive 1MM USD in exchange of 30MM MXN

We can buy that particular day 30MM using only $857, 142.86

Hence the Future Value = +1,000,000 – 857,142.86 = 142,857.14

This is still future value which should be bring into present value

NPV = FV * DF

NPV = 142,857.14 * .98 = 140,000

Risk:

There will be two types of risk:

1. Market risk -> FX spot risk, FX forward points risk( PV01 risk on Basis adjusted interest rate curve)  and USD interest rate risk
2. Credit Risk -> Counterparty Risk – After two months we made $140K but it is not realized yet . It means on the books but no generated in cash till the maturity date. What if the counterparty defaults. We loose this gain.
3. P&L Attribution:
   1. Current time Spot rate vs Previous spot rate difference.
   1. Current FX forward rate vs Previous FX forward rate difference. The basis adjusted interest rate curve is generated and hence PV01. Hence, the attribution is not directly on FX forward points but basis adjusted interest rate behind it.
   1. USD Discount factor change. Eventually the change in DF.
4. Accounting: The NPV of $140K will be debited to Assets and credited to P&L accounts. There will be increase in Assets and increase in equity via P&L

Collateral: As mentioned above there is counterparty risk. We would need the counterparty give some security to protect our interest as per the agreement