A Lagos exporter will receive $800,000 in three months. If the dollar drops against the naira meanwhile, the receipt shrinks. The exporter can ask a bank to fix the rate today, or it can borrow dollars now and repay from the receipt. Both lock in the amount in naira. A third way costs almost nothing: match the receipts and payments in the same currency so that only the difference is exposed.
This topic covers forward rates quoted as premiums and discounts, forward exchange contracts, cross rates, leading and lagging, netting and the money market hedge for receipts and payments. The previous topic covered exchange rate relationships. The next covers duration and convexity. The May 2014 and November 2014 Pathfinder papers included foreign exchange questions.
In 30 seconds
A forward exchange contract fixes the amount, currency, date and rate now. Forward rates are quoted as premium or discount points on spot. Direct quote: add a premium, deduct a discount. Indirect quote: deduct a premium, add a discount. The bank uses the rate better for itself. Cross rate: combine two rates through a common currency.
Leading (pay early if the foreign currency will rise) and lagging (pay late if it will fall). Netting: offset receipts and payments in the same currency and hedge only the net. Money market hedge for a receipt: borrow foreign currency now (amount = receipt ÷ (1 + period rate)), convert at spot, deposit the home currency. For a payment: deposit foreign currency now (amount = payment ÷ (1 + period rate)), bought by borrowing home currency at spot.
The effective rate = foreign amount ÷ home currency result. Hedging removes gains as well as losses.
Key terms in plain English
| Term | What it means |
|---|---|
| Forward exchange contract | A bank contract to buy or sell currency at a fixed rate on a fixed future date |
| Premium / discount | The forward rate is stronger / weaker than spot, quoted in points |
| Cross rate | A rate between two currencies derived from each one’s rate against a third |
| Leading / lagging | Paying early / late to gain from expected rate moves |
| Netting | Offsetting same-currency receipts and payments |
| Money market hedge | Fixing a rate by borrowing and depositing in two currencies |
Syllabus check
This topic is in syllabus area E (treasury and advanced risk management). It covers:
- adjusting a spot rate to arrive at a forward rate;
- explaining and evaluating forward exchange contracts and money market hedges.
CAMA 2020 and hedging
The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria.
| Section | What it says | Link to this topic |
|---|---|---|
| s. 305 | A director must act in good faith in the best interests of the company | Hedging should be used to protect the company, not to speculate |
| s. 308 | A director must use the care, diligence and skill of a reasonably prudent director | Directors should approve a clear policy for managing currency risk |
| s. 377(1) and s. 378 | Directors prepare statements that follow IFRS and give a true and fair view | Decisions later affect reported assets, profit and cash |
| s. 385 | The directors’ report covers performance and risk | Major plans and risks are reported to shareholders |
Forward rates and contracts
Banks trade currency spot or at a forward rate. Forward rates differ from spot because of interest rate differences (see interest rate parity). A forward exchange contract is a contract between a customer and a bank for a specified amount of a specified currency, delivered on a specified date at a specified rate.
Quoted periods are one, three and six months and a year; beyond a year is unusual except for the most traded currencies. The contract removes the uncertainty of the future rate and fixes the home-currency amount.
Premiums and discounts
Forward rates are quoted as adjustments to spot. A premium means the forward rate is stronger than spot; a discount means weaker.
| Quote | Premium | Discount |
|---|---|---|
| Direct (e.g. ₦ per $) | Add to spot | Deduct from spot |
| Indirect (e.g. $ per £) | Deduct from spot | Add to spot |
Forward adjustments are quoted as spreads like the spot rate and may be in points (240 means 0.0240). ICAN’s direct example: spot ₦150 with a premium of 7.14 gives 157.14; a discount of 6.82 gives 143.18.
ICAN’s example. A UK company expects $75,000 in six months. Spot (US$/£1) is 1.7530 – 1.7540; six months forward is 240 – 231 pm.
- The company sells dollars for pounds, so the bank gives it the less favourable rate: the higher number, 1.7540.
- The dollar is at a premium, so deduct the smaller points, 0.0231: forward = 1.7309.
- Receipt = 75,000 ÷ 1.7309 = £43,330, fixed now.
Spot can move either way. If an Italian company expects 5 million yen in three months at 135.00 yen/€ (€37,037) and the yen falls to 150, it receives €33,333; if it rises to 120, €41,667. A forward contract fixes the amount.
Cross rates
Combine two rates through a common currency. If ₦150 = $1 and $1 = SwFr1.2166, then ₦150 = SwFr1.2166, so SwFr1 = 150 ÷ 1.2166 = ₦123.29. If £1 = $1.8610 and $1 = SwFr1.2166, then £1 = 1.2166 × 1.8610 = SwFr2.2641. For ICAN’s peso example (spot 11.2470 – 11.2485 pesos per $, three months forward 340 – 360 discount), the company buying pesos uses 11.2470 + 0.0340 = 11.2810, so 10,000,000 pesos cost 10,000,000 ÷ 11.2810 = $886,446.
Other ways to hedge
Hedging aims to remove the chance that a future transaction is done at a worse rate, even though this gives up favourable moves. Methods: leading and lagging, netting, forward contracts, money market hedges, currency futures, options and swaps (later topics).
Leading and lagging
Leading is paying early, to pay in a currency expected to rise against your own. Lagging is paying as late as possible in a currency expected to fall. A Nigerian buyer owing Ghanaian cedis who expects the naira to fall may pay at once. A Japanese company owing dollars that expects the dollar to fall may delay.
Netting
When a company has receipts and payments in the same currency at about the same time, it uses one to pay the other, so the exposure is only the net amount. A Nigerian company expecting $400,000 of receipts and $600,000 of payments in two months nets $400,000 and is left with a $200,000 payment, which may be hedged with a forward contract.
Money market hedges
Here the company borrows or lends in the money markets now, so that the future flow settles the loan or deposit and the rate is fixed today.
For a future receipt
Borrow foreign currency now, convert it at spot, and (in the exam) deposit the home currency. When the foreign receipt arrives it repays the loan. ICAN’s example: a UK company expects $800,000 in three months. Spot (US$/£) is 1.7770 – 1.7780. Three-month rates: US dollar deposit 4.125%, borrowing 4.250%; sterling deposit 6.500%, borrowing 6.625%.
- Borrow dollars at 4.25% × 3÷12 = 1.0625%: amount = 800,000 ÷ 1.010625 = $791,589.
- Sell them at 1.7780 to get £445,213; deposit at 6.5% × 3÷12 = 1.625%: £445,213 × 1.01625 = £452,448.
- The $800,000 repays the loan.
Effective rate = 800,000 ÷ 452,448 = $1.7682/£.
For a future payment
Deposit foreign currency now, so that the deposit plus interest equals the payment, buying the currency by borrowing home currency. ICAN’s example: a UK company pays $500,000 in six months. Dollar deposit rate 4.125%, sterling borrowing rate 6.625%, spot 1.7770 – 1.7780.
- Deposit dollars at 4.125% × 6÷12 = 2.0625%: amount = 500,000 ÷ 1.020625 = $489,897.
- Buy at 1.7770 for £275,687; borrow sterling at 6.625% × 6÷12 = 3.3125%: owed = 275,687 × 1.033125 = £284,819.
- Effective rate.
500,000 ÷ 284,819 = $1.7555/£.
The sterling rate used is the borrowing rate, because the company borrows sterling. In theory a money market hedge gives a rate similar to the forward rate, but exam data may make one better. Expect to compare them and recommend.
The rules in more depth
Why the bank takes the worse rate for the customer
That is its margin. Use the spot spread to decide which side applies.
Why premium and discount flip with the quote
A stronger foreign currency is a bigger number in a direct quote and a smaller number in an indirect quote.
Why netting is cheapest
No bank charge is needed for the part that offsets.
Why the money market hedge works
The loan or deposit in the foreign currency exactly matches the future flow, so its value in home currency is fixed today.
Effect on analysis
Compute the hedged outcome for each method, compare, and recommend. Add that a forward contract is simple and a money market hedge needs borrowing capacity.
Worked examples
Example 1: a forward receipt. A Nigerian exporter will receive $200,000. Spot is ₦1,500/$ and the dollar is at a forward premium of ₦60.
- Forward rate.
1,500 + 60 = ₦1,560. - Receipt = 200,000 × 1,560.
- Receipt = ₦312m, fixed.
Example 2: netting. A company will receive €300,000 and pay €450,000 in the same month.
- Net = 450,000 − 300,000.
- Exposure = €150,000 payable.
- Only this amount needs a hedge.
Example 3: an indirect premium. Spot is $1.7540/£ and the dollar is at a premium of 0.0150.
- Indirect quote: deduct a premium.
- Forward = 1.7540 − 0.0150.
- Forward = $1.7390/£.
Example 4: a part-year rate. A dollar deposit rate is 6% a year and the hedge is for four months.
- Period rate = 6% × 4÷12.
- Period rate = 2%.
- Deposit = payment ÷ 1.02.
How to score full marks
- Decide whether the company buys or sells the foreign currency.
- Pick the rate better for the bank.
- Apply the premium or discount correctly for the quote.
- Use part-year interest rates.
- Show each step of a money market hedge and the effective rate.
- Compare methods and recommend, noting that hedging gives up gains.
Common mistakes in the exam
- Adding a premium to an indirect quote.
- Using the wrong side of the spot spread.
- Using annual interest rates for part-year hedges.
- Borrowing when you should deposit, or the reverse.
- Forgetting to net first.
- Not stating that hedging gives up favourable moves.
Quick revision
- Forward contract fixes amount, date and rate.
- Direct: premium add, discount deduct. Indirect: the reverse.
- Bank uses the rate better for itself.
- Netting before hedging; lead or lag on expected moves.
- MMH receipt: borrow foreign; payment: deposit foreign.
- Effective rate = foreign amount ÷ home result.
- CAMA 2020: ss. 305, 308, 377(1), 378, 385.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.
Recall check: multiple choice
Recent ICAN papers are written, although older papers such as May 2014 included multiple-choice questions. These questions are for quick recall. The written questions that follow are closer to the exam.
Question 1. A forward exchange contract fixes:
- Amount, currency, date and rate
- Only the rate
- Only the date
- The tax
Show the answer
A. All four now.
Question 2. For a direct quote, a forward premium is:
- Added to spot
- Deducted from spot
- Ignored
- Divided
Show the answer
A. The foreign currency is stronger.
Question 3. For an indirect quote, a forward premium is:
- Deducted from spot
- Added to spot
- Ignored
- Multiplied
Show the answer
A. The reverse.
Question 4. Leading means:
- Paying early
- Paying late
- Netting
- Borrowing
Show the answer
A. To pay before the currency rises.
Question 5. Netting leaves an exposure equal to:
- The difference between receipts and payments
- Their sum
- Zero always
- The larger flow
Show the answer
A. Same currency, same time.
Question 6. To hedge a future foreign currency receipt with a money market hedge, borrow:
- The foreign currency now
- The home currency now
- Nothing
- Gold
Show the answer
A. The receipt repays the loan.
Question 7. To hedge a future foreign currency payment, deposit:
- The foreign currency now
- The home currency
- Nothing
- A bond
Show the answer
A. So the deposit funds the payment.
Question 8. A three-month hedge with an annual rate of 8% uses:
- 2%
- 8%
- 24%
- 0.8%
Show the answer
A. 8 × 3 ÷ 12.
Question 9. Hedging usually:
- Gives up favourable moves too
- Gives only gains
- Has no cost
- Is illegal
Show the answer
A. It fixes the outcome.
Question 10. Which section of CAMA 2020 sets the director’s duty of care and skill?
- Section 308
- Section 400
- Section 405
- Section 409
Show the answer
A. Directors should test the assumptions behind a decision.
Written questions
Question 11 (10 marks). (a) Describe a forward exchange contract. (3 marks) (b) Explain leading and lagging. (4 marks) (c) Explain netting with an example. (3 marks)
Question 12 (20 marks). A UK company will receive $800,000 in three months. Spot (US$/£) is 1.7770 – 1.7780 and the three-month forward is 105 – 100 premium. Three-month interest rates: dollar deposit 4.125%, borrowing 4.250%; sterling deposit 6.500%, borrowing 6.625% (annual). (a) Calculate the sterling received under a forward contract. (4 marks) (b) Calculate the sterling received under a money market hedge and the effective rate. (8 marks) (c) Recommend the better method.
(2 marks) (d) Explain why a company might prefer a forward contract and state two reasons hedging gives up gains. (6 marks)
Question 13 (10 marks). (a) An Italian company expects 5 million yen in three months. Spot is 135.00 yen/€. Calculate the euro value at spot and if the rate is 150 and 120. (4 marks) (b) Given ₦150 = $1 and $1 = SwFr1.2166, find the naira per franc. (3 marks) (c) A company receives $400,000 and pays $600,000 in two months. Show the netted exposure. (3 marks)
Model answers
Show the model answer to Question 11
(a) Forward contract (3 marks). A contract between a customer and a bank to buy or sell a specified amount of a specified currency (1) on a specified future date (1) at a rate fixed now. (1)
(b) Leading and lagging (4 marks). Leading is paying early, to pay in a currency expected to rise against your own. (2) Lagging is paying as late as possible in a currency expected to fall. (2)
(c) Netting (3 marks). Receipts in a currency are used to pay payments in the same currency at about the same time. (1.5) For $400,000 of receipts and $600,000 of payments, only $200,000 is exposed. (1.5)
Show the model answer to Question 12
(a) Forward (4 marks).
- The company sells dollars, so the bank gives the higher number, 1.7780. (1)
- The dollar is at a premium in an indirect quote, so deduct the smaller points, 0.0100: 1.7680. (1.5)
- £ = 800,000 ÷ 1.7680 = £452,489. (1.5)
(b) Money market hedge (8 marks).
- Borrow dollars at 4.25% × 3÷12 = 1.0625%: 800,000 ÷ 1.010625 = $791,589. (3)
- Sell at 1.7780: £445,213. (2)
- Deposit at 6.5% × 3÷12 = 1.625%: £452,448. (2)
- Effective rate.
800,000 ÷ 452,448 = 1.7682. (1)
(c) Recommendation (2 marks). The forward contract gives £452,489, about £41 more than the money market hedge (£452,448), so it is slightly better, and it is simpler. (2)
(d) Explanation (6 marks). A forward contract is simple, needs no borrowing and fixes the amount. (2) Hedging gives up gains because the rate is fixed in advance. (2) A company that wants to protect its margin accepts this. (2)
Show the model answer to Question 13
(a) Yen (4 marks).
- At 135: 5,000,000 ÷ 135 = €37,037. (1.5)
- At 150: €33,333. (1)
- At 120: €41,667. (1.5)
(b) Cross rate (3 marks). ₦150 = SwFr1.2166, so SwFr1 = 150 ÷ 1.2166 = ₦123.29. (3)
(c) Netting (3 marks).
- Net = 600,000 − 400,000 = $200,000 payable. (2)
- This residual may be hedged with a forward contract. (1)
Pathfinder on Forward rates, cross rates, leading and lagging, netting and money market hedges
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Question 6 included a forward discount calculation, with the dollar at a discount of about 3.7%. Practise the premium and discount rules in the section on forward rates.
Revise first: Forward rates and contracts
Question 7 was a foreign exchange question that combined retention money, a money market hedge and forward contracts. Read the section on money market hedges and the worked examples.
Revise first: Money market hedges
Source: ICAN Pathfinder, Strategic Financial Management. Diets covered: May 2014 question 6 and November 2014 question 7.
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