Forum Archive Index - May 2002

["trader 100" <trader_100@hotmail.com>]

Hi Snoopy,

I thought I'd have a crack at some of the issues you raise.

The counterparty to a NZ Company Hedge will invariably be a bank.  In the 
case of a forward contract we a talking about an agreement to buy / sell 
currency at a future date at a price agreed on today where the price is 
simply spot +/- an interest adjustment.  For a NZ importer (ie a NZD/USD 
seller) the forward points are negative because NZ interest rates are higher 
than US interest rates.  If it wants to hedge using a forward contract one 
year out it will approach a bank and enter into an agreement to sell NZD to 
the bank in one year (and receive USD). No funds change hands between the 
two at this point.  However, the bank won't want to take the risk of having 
to deliver USD in one years time at a rate that could potentially be worse 
than the prevailing spot rate so it will purchase the USD on the day the 
forward contract is arranged.  The trouble is the USD it is holding on its 
counterparties behalf for a year are only earning say 1.75% interest while 
the NZD it just swapped for the USD could have earned say 5.5% interest.  
The bank needs to be compensated for this so the forward rate is less than 
the current spot rate by an amount exactly equal to the interest 
differential.  Note that the NZ Company could have achieved the same result 
by borrowing USD and holding them for a year.  Because of this ability to 
arbitrage the forward points will always be equal to the interest 
differential.

Regards,

T100.


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