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Is a Forward Exchange Contract with Optional Delivery the Worst Hedging Product You Could Buy?

Updated on July 19, 2012

What is a Forward Exchange Contract with Optional Delivery

I am glad you asked. Please note different FX providers will have different names for a similiar product so you need to be aware of the mechanics of the deal you are buying into.

Put simply a Bank or FX provider will offer a forward exchange contract which can be delivered at any time during a set period without a pre-delivery adjustment. The selling point is that the customer has certainty over the exchange rate throughout the delivery period. Many providers will say that the contract cannot be extended beyond the initial due date. When in a competitive quote situation the dealer showing this type of product can afford to show a tighter spot price. Why? because the customer is getting buried on the forward rate.

It is easier to demonstrate this scenario by example.

A typical small customer

Barry's Bike Shop Pty Ltd imports bikes worth USD $100,000 every month. Barry is on good terms with his supplier and makes a monthly Telegraphic Transfer through Bank A. Barry is a long standing client of Bank A and has decided that he would like to hedge his risk for the next six months by locking into a forward exchange contract. He has also decided to seek a competitive quote from Bank B which have been calling him daily for the last month assuring Barry that they can provide a better quote.

Barry does not have a strong understanding of Forward Exchange and has been confused with forwards points adjustments on pre-deliveries and extensions in the past.

 
Market
Bank A FEC
Bank B FEC with Optional Delivery for the full term
Spot AUDUSD (Bank Sells USD)
1.0780
1.0760
1.0775
Forward Points 6 months
-0.0180
-0.0185
-.0180
End Rate
1.0600
1.0575
1.0595
AUD required to buy 600k USD
566,037.74
$567,375.89
$566,304.86

Barry does not know the market pricing. It is included in the chart for your reference. He decides to take the offer from Bank B because it is AUD 1,071.03 cheaper than the FEC from Bank A. Unfortunately Barry's logic does not take into account the forward points adjustment on predeliveries when he makes his payment. In this example I will use 25 pips per month straight line. Barry predelivers USD 100k per month to cover his payments. The rates he achieves are as follows:

 
Bank A Predelivery
AUD Equivalent
Bank B Predelivery
AUD Equivalent
5mth predeliver USD 100,000
1.0575 + 0.0125 = 1.0700
93,457.94
1.0595
94,384.14
4mth predeliver USD 100,000
1.0575 + 0.0100 = 1.0675
93,703.15
1.0595
94,384.14
3mth predeliver USD 100,000
1.0575 + 0.0075 = 1.0650
93,896.71
1.0595
94,384.14
2mth predeliver USD 100,000
1.0575 + 0.0050 = 1.0625
94,117.64
1.0595
94,384.14
1mth predeliver USD 100,000
1.0575 + 0.0025 = 1.0600
94,339.62
1.0595
94,384.14
expiry deliver USD 100,000
1.0575 + 0.000 = 1.0575
94,562.65
1.0595
94,384.14

The first thing we notice is that all except one of the predeliveries from Bank A are favourable to the optional delivery offered by Bank B. Over the life of the deal the Bank A trades would have cost AUD 564,077.71 which is AUD 2,227.15 cheaper than Bank B and that is after Bank A made 25 points (20 on the spot and 5 on the forward) on the establishment of the deal.


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