A foreign exchange (FX) forward index is an indicative representation (average) of prices on the FX forward market published by commercial banks operating on the Georgian financial market. Calculation of the FX forward index is based on FX forward rates determined by commercial banks on the interbank FX forward market. Individuals and companies make FX forward deals with those commercial banks who offer such services (currently ten commercial banks in Georgia do this). A forward price for an individual FX forward contract is determined by a commercial bank, however the FX forward index published by the NBG will allow a customer to have a better understanding of prices (average prices) on the FX forward market.
FX forward contracts are broadly used financial instruments to hedge FX risks. FX forward contracts allow us to make an FX deal today with a predetermined exchange rate, with the settlement of the deal taking place in the future. The FX forward index represents the difference between the market interest rates of two currencies. The FX forward index is NOT a forecast of an exchange rate.
Example: If the purchase price (bid) of a 1-month FX forward of Bank X for a specific date is 40.55 and the spot exchange rate of USD/GEL for the bank on the same day is 1.6270, then a client can make an FX forward deal with the bank for which the forward exchange rate will be 1.6311 (1.6270+40.55/10000=1.6311).
The FX forward index is updated and published daily on the homepage of the the official website of NBG.
A company that has a mismatch in the currencies of its assets and liabilities faces a risk due to a change in the exchange rate – so-called FX risk. Companies involved in international trade are more exposed to FX risk due to the nature of their business.
FX risk makes the economic planning process for businesses difficult and financial outcomes uncertain.
Who is exposed to FX risk?
• Exporters
Exporters pay for goods in the national currency while their revenues are denominated in a foreign currency. The appreciation of the national currency means getting less lari revenues for an exporter who sells products abroad and the opposite, more lari revenues, if the national currency depreciates.
• Importers:
Importers pay for imported goods in a foreign currency and receive revenues in the domestic currency. Unlike exporters, the depreciation of the lari is unfavorable for importers as they will have to pay more of their lari reserves to suppliers in a foreign currency. If the national currency appreciates, an importer will have to pay less amounts of lari.
• Organizations and individuals who have revenues in the national currency and their liabilities are denominated in a foreign currency, or vice versa, are exposed to FX risk.
FX risk makes financial outcomes uncertain for exporters and importers as they cannot incorporate FX risk in their price setting process and this also makes the business planning process hard.
FX hedging is a way to reduce the FX risk. This can be achieved by appropriately planning business processes or by using various financial instruments.
Various hedging instruments are used to minimize FX risk. The main purpose of FX hedging is to avoid the uncertainty associated with exchange rate fluctuations.
FX hedging enables importers and exporters to:
• Project cash flows in different currencies;
• Determine the prices that were foreseen in business plans;
• Maintain operational stability.
The best way of hedging is "natural hedging". Natural hedging implies conducting business processes in a way that the currencies of cash inflows and outflows (revenues and expenditures) are matched. This enables the FX risk to be minimized.
Natural FX hedging enables the avoidance of the extra costs of hedging and is directly related to companies' business operations. However, not all companies are capable of using natural hedging.
The following instruments are used for FX hedging:
• FX forwards are agreements when one party buys a certain currency from another party with a predetermined exchange rate on a date agreed in advance;
• FX swaps are agreements of simultaneous purchase and sale of two currencies by involved parties at predetermined exchange rates on different settlement dates;
• FX options are agreements that give a buyer the right (not the responsibility) to buy or sell a certain currency at a predetermined exchange rate before or on the date of settlement. The buyer has to pay a fee for the option.
The exchange rate for an FX forward is calculated based on the current exchange rates of the currencies and the interest rate differential of these two currencies. For instance, if the interest rate for a foreign currency is less than the rates on the lari, the foreign currency can be bought in future at an exchange rate higher than the current one. If the interest rate is higher for a foreign currency compared to lari rates, then this foreign currency can be bought in future at an exchange rate lower than the current one.
The forward exchange rate can be calculated using following formula:
F - forward exchange rate;
S - spot exchange rate (at the date of agreement);
Rd - annual interest rate for domestic currency;
Rf - annual interest rate for foreign currency;
D - forward maturity (days).
The forward rate is not a forecast of the exchange rate, but rather the rate computed based on exchange rate differentials.
The buyer of foreign currency with an FX forward would face extra costs if the exchange rate on the settlement date is lower than the previously agreed forward exchange rate.
The seller of the foreign currency with an FX forward would face potential profit if the exchange rate on the settlement date is higher than the previously agreed forward exchange rate.
Both cases reveal possible extra costs associated with FX forwards. However, this is the cost that the companies pay to avoid uncertainty and be secured.
Companies involved in both - export and import operations - with the same currency will face lower exchange rate risks compared to companies doing only export or import.
For instance, consider an exporter company that uses resources mostly imported from abroad. If that company pays for resources in a foreign currency and receives revenues from exports in the same foreign currency, then that partially reduces FX risk. Therefore, companies that have most of their expenses and revenues denominated in the same currency will not be exposed to significant FX risk.
Examples:
How can an importer do FX hedging?
Consider a company that imports products in a foreign currency and sells on local markets in the local currency, the lari. For this company, most of the expenses are denominated in a foreign currency, while revenues are received in lari.
For instance, consider a company importing products worth 1 million USD on credit and the mark-up is 20%. The company should thus receive 1.2 million USD to cover the costs of the imported goods and receive enough profit. The importer thus sets the price based on these calculations. However, the company is exposed to FX risk. If the local currency depreciates by the date of the credit settlement, the importer, after conversions, will be left with fewer profits in the foreign currency than it had anticipated.
To avoid the FX risk, the company can secure a forward to buy 1 million USD at a future date. By means of this instrument, the company will be able to determine the exchange rate for converting lari revenues and will make the price setting process more accurate. The maturity of the contract will depend on the settlement date of foreign currency liabilities.
Which financial instrument should be used when the need for foreign currency is uncertain?
Consider a company that is participating in an auction/tender and has indicated the price in lari in advance. The results of the auction/tender will be known in a month. If the company wins, it will have to supply goods worth 1 million USD at the predefined price and the revenues will be denominated in the local currency. Thus, if it wins the auction, the company is exposed to FX risk if the local currency depreciates compared to the date of auction application. The company will have fewer profits after paying the 1 million USD for the supplied goods. The company should secure an FX option for buying 1 million USD to avoid the FX risks.
Therefore, if the lari depreciates, the company will use the FX option and buy 1 million USD at the predetermined exchange rate. If the lari appreciates and/or the company does not win the auction/tender, it will not use the option. The FX option enables the owner to refuse purchase of the foreign currency, although it will still have to pay the relevant fee imposed by the bank.
Consider a company that has excess foreign resources in foreign currency and needs lari, but will need the foreign currency again in future. What should it do?
Let's consider a company that has 10,000 USD on account and its revenues are denominated in the local currency. If this company has to pay local currency liabilities now, but will need the foreign currency in the future, it can secure a swap agreement. This contract will allow the company to buy lari now with the foreign currency it has and in the future get its foreign currency back at a predetermined exchange rate.
Swap contracts can be secured with banks. Also companies that have opposite needs for currencies can perform swap operations with each other.