Forex: The Forward Coverage in Forex

When coverage is for a specific transaction, there is little more that can be done except to consider the best market in which to purchase it.

Forward coverage, when needed for an investment or other position in a particular currency, there are several possibilities because of the structure of the forward exchange market.

The method resulting in the least cost would be to take a forward position the day before a currency change and close it out the day after. That is not possible, so forwards must be obtained for longer periods.

Coverage beyond three months must generally be negotiated. There are two factors to be considered: the differential between months and the level of the spot rate. What that means is that if six times the one-month differential over spot is more or less than the six-month differential, it might be cheaper, if the spot rate does not move, to plan to have six consecutive one-month contracts instead of one six-month contract.

If the currency is getting stronger and the spread is narrowing, then shorter contracts are to be preferred. The reverse is true when the spread is widening.

The position of the spot rate also is important. When the spot rate is near its upper limit, it is less costly to sell forward. Not only is the currency then exhibiting strength, but if it became weak, it would tend to fall toward its lower limit. That would reduce the cost of the forward coverage.

Since the objective is to provide continuing coverage, consideration should be given to settling outstanding contracts before their due dates and entering into new contracts at or about at the same time. That can reduce the expense of coverage when the short rates are more than pro rata to long rates.

Suppose, as an example that a six-month forward sale contract is entered into at a spread of 60 points. At the end of three months, the three-month spread is 35 points and the forward is still at 60. It is obviously advantageous to buy the original three-month contract in and enter into a new six-month contract.

Changes in the spot rate on that kind of transaction make no difference, since a loss on one contract from that cause is exactly offset by a compensating change in the rate on the other contract.

There is one further forward coverage consideration. As has been pointed out, devaluations and revaluations occur at a particular instant that cannot usually be pinpointed in advance. In addition, forward rates are cheapest when there is no pressure on a currency, but that is the very time when coverage does not seem necessary. One way to cope with the situation is to enter into contracts on both sides but for different periods, so that one runs off and leaves the protection on the other side.