Cost of Coverage in Forex

Cost has an important bearing on both amount and period, particularly when nonspecific transactions are concerned. At times, the cost could exceed the possible loss, so that having protection would be more expensive than not having it.

Most of the examples that have been given have involved spot and forward rates at a moment in time and have shown what can happen when rate changes are caused by revaluation or devaluation. However, most such changes take place rarely and the vast majority of changes in rates in the past have occurred within narrow parity limits.

The cost then is related to two things: the difference in rates and the period of time. At the moment in time, it is possible to obtain quotations that give the spot rate and the difference between that rate and the forward premiums or discounts usually fro periods of 1, 2, 3, 6, and 12 months.

When he negotiates a particular transaction, the businessman can buy or sell a foreign currency forward at a fixed price, and that gives him, in terms of his own currency, a future determinable value. In that type of transaction, the cost is usually considered to be the differential between the spot rate and the forward rate.

All this becomes obvious when the foreign exchange for a particular forward contract is bought or sold on the delivery date in the open market rather than derived form the proceeds of a business transaction. The difference between the original forward rate and the spot rate used to settle the contract is the true cost or profit. The forward rate is derived form the spot rate at a moment in time plus or minus the forward differential, but that is not the cost. It is merely a conventional means of expressing the forward rate.

As example, the spot rate for sterling is $2,4050 per pound. Actually, a quotation may be $2,4049 to $2,4051, depending on whether sterling is bought or sold. The three-month forward rate is at a discount of $0.0060, or $2.3990. That is usually expressed as a percent per annum, in this case approximately 1 percent ($0.024 to $2.3990).

Sterling is sold forward, and at the end of three months the seller has to deliver sterling he already has or buy sterling to deliver. Say he buys it in the open market at $2.3850. The seller has a profit of $0.0140 per pound on this particular transaction. Or to make a different assumption, spot sterling is at $2.41 on the delivery date.

Now the cost of the transaction is $0.012 per pound or 2 percent per annum. Changes of that magnitude can take place very rapidly because of market forces, and that can quite violently influence the cost.