Traders seek to lock in prices as they fight volatile market
RECORD volatility and unpredictability in the foreign exchange markets during the financial crisis may have seen volumes soar and day traders profit handsomely, but if you are a longer-term positional trader dipping into the forex markets or looking to hedge your trading, whether it be in the currency markets or another asset class, then volatility and uncertainty are not your friends.
The desire of some to eliminate them from the currency markets has led to the use of forward contracts soaring by 40 per cent in the first half of 2009 compared to the same period in 2008, according to figures from currency broker World First.
The broker said that the trend emerged in November 2008, when the proportion of forward contracts increased by 30 per cent compared to the previous month. This was at the same time that sterling fluctuated around 8 per cent against both the US dollar and the euro.
And there has been a steady rise in the number of forward contracts booked compared to spot rate deals ever since – last month saw the largest number to date. Elisabeth Dobson, head of private clients at the broker, said: “Currency markets usually price in any news or announcements weeks in advance making it relatively stable. However, since November 2008 we have been sailing in unchartered waters. Experts are struggling to make accurate predictions as even the seemingly insignificant news can cause daily fluctuations of over 3 per cent.”
World First is not alone in seeing this rise in forward contracts either. Foreign Currency Direct (FCD) has also noticed increased use of forward contracts in recent months. Leigh Smith, senior executive dealer at FCD, says: “Clients are now witnessing rates that have not been achievable for over seven months and – with predictions circulating that the UK could be witnessing a W-shaped recession – may disappear once more during the months ahead.”
Forward contracts are ideal for those who want to lock in the current rate of exchange between two currencies and thus protect themselves against any subsequent moves in the market.
STERLING SLUMP
Mark O’Sullivan, director at Currencies Direct, says that many clients pulled out of such purchases last Christmas when sterling slumped against the euro (see chart, right), because the change in the exchange rate meant that they simply couldn’t afford to take the transaction through.
“People got absolutely hammered and last year was certainly a wake-up call as to how volatile currency markets can be. The use of forward contracts takes the emotion out of the forex markets,” he says.
Private forex traders can benefit from forward contracts very easily. O’Sullivan says that there is normally no risk premium on them, clients simply pay an initial deposit, which is normally between 5 and 10 per cent of the value of the contract and choose a date, within two years, at which they want delivery. Unlike options, forward contracts have no time value.
While the benefit of forward contracts is evident for businesses, private clients who trade regularly in the forex markets may wish to hedge their trading using a forward contract. For example, you may think that sterling has further to rise from its current level against the dollar and go long. However, you could also buy a forward contract, which will lock in your rate.
Alternatively you may think that sterling will weaken substantially against the dollar over the rest of the year and this would make US equities relatively expensive in six months time. But by choosing a forward contract, you can ask for £100,000 worth of dollars to be delivered to you in six months time at the current rate and US equities will be no more expensive than they are now.
Whether you are purely a forex trader, have a mix of asset classes in your portfolio, or simply need to make international payments over a period of time, the impact of currencies can have a major effect on your trading and purchasing power. Forward contracts only serve to simplify your life and give you that certainty that you sometimes need.