Here’s a very basic example. Vitaly Partners, an Italian company, wants to hedge against the euro by buying dollars. Vitaly agrees on a currency swap with Brand USA, an American company. Over five years, Vitaly sends Brand USA €1,000,000 in exchange for the dollar equivalent, about $1,400,000. Vitaly agrees to swap interest payments with Brand USA as well: Vitaly will pay Brand USA 6% interest on its swapped principal, €1,000,000, while Brand USA will pay Vitaly 4. 5% interest on its swapped principal, $1,400,000.
Vitaly agreed to swap €1,000,000 at 6% to Brand USA in exchange for $1,400,000 at 4. 5%. Let’s assume that interest rate payments are swapped every six months. Vitaly’s interest rate payment will be calculated as follows: Notional principal x interest rate x frequency. Every six months, Vitaly will pay Brand USA €30,000, in euros. (€1,000,000 x . 06 x . 5 [180 days/360 days] = €30,000. ) Brand USA’s interest rate payment will be calculated as follows: $1,400,000 x . 045 x . 5 = $31,500. Brand USA will pay Vitaly $31,500, in dollars, every six months.
Dave is worried that the price of the dollar is going to plummet relative to the British pound. He has $1,000,000 in cash, which would fetch him about £600,000 at the then-current exchange rate. Dave wants to use a forward contract to lock in the exchange rate of the dollar relative to the pound. Here’s what Dave does: Dave offers to sell Vivian $1,000,000 of US currency in exchange for £600,000 of British currency in six months. Vivian accepts the deal. This is a “forward contract. "
The price of the dollar goes up relative to the pound. Hypothetically, let’s say one dollar now fetches . 75 pound instead of . 6 pound. Dave pays Vivian the difference between the current price of exchange and the price agreed upon in the contract: ($1,000,000 x . 75) - ($1,000,000 x . 6) = $150,000. The price of the dollar goes down relative to the pound. Hypothetically, let’s say one dollar now fetches . 45 pound instead of . 6 pound. Vivian agreed to pay Dave . 6 pound for each of his dollars six months ago, so Vivian has to pay Dave the difference between the price agreed upon in the contract and the current price: ($1,000,000 x . 6) - ($1,000,000 x . 45) = $150,000. The exchange rate between the dollar and the pound stays the same. No exchange happens between partners in the contract.
If the dollar gained in value, Dave is a winner, although he still has to pay out. If one dollar fetches . 75 pound instead of . 6, Dave has to pay Vivian $150,000, but his million dollars suddenly buys a lot more pounds. If the dollar fell in value, Dave isn’t a loser. Remember, Vivian owes him the exchange rate they agreed upon at the beginning of the contract. So it’s as if the value of the dollar never fell. Dave takes the payout, none the poorer than he was before.
When the specific date (known as the expiration date) of the contract arrives, the buyer of the contract can exercise the option at the agreed price (known as the strike price), if currency fluctuations have made it profitable for him/her. If fluctuations have made the option worthless, it expires without the company or individual exercising it.
