Why would financial institution do a forward transaction?
“Forwards” (as opposed to “spot” and “futures”) are used to hedge the financial institution positions against risk. Forwards are commonly used to hedge currency and interest rate risk. Let’s say you own a bank – let’s call it Flameboy Savings & Loan (FBSL). FBSL takes deposits and in turn loans it out. It packages the loans to securitize them, sells them off to guys like FNMA. You make profits by making the net yield spread between the interest rate you loan out at and the interest you pay to depositors. Let’s say you loan out $10,000 to somebody for a 5 year fixed balloon payment. Now let’s say you want to lock in a profit margin, where FBSL agrees to sell a forward. The forward will be based on market rates at the time. Let’s say you agree to pay a fixed rate, say 2%, at a set period of time in the future. Let’s say that’s 10 years. Now, assuming that nobody defaults, you have just locked in 3% profit margin that will settle in 10 years. Let’s say FBSL has a branch in Japan. Your Jap
