Forward exchange contract is a device which can afford adequate protection to an importer or an exporter against exchange risk. Under a forward exchange contract a banker and a customer or another banker enter into a contract to buy or sell a fixed amount of foreign currency on a specified future date as a predetermined rate of exchange. Our exporter, for instance, instead of groping in the dark or making a wild guess about what the future rate would be, enters into a contract with his banker immediately. He agrees to sell foreign exchange of specified amount and currency at a specified future date. The banker on his part agrees to buy this at a specified rate of exchange. The exporter is thus assured of his price in the local currency. In our example, the exporter may enter into a forward contract with the bank for 3 months delivery at Rs.49.50. This rate, as on the date of contract, is known as 3 months forward rate. When the exporter submits his bill under the contract, the banker would purchase it at the rate of Rs.49.50 irrespective of the spot rate then prevailing.
Date of Delivery
According to Rule 7 of FEDAI, a ‘forward contract’ is deliverable at a future date, duration of the contract being computed from the spot value date of the transactions. Thus the 3 months forward contract is booked on 12th February, the period of two months should commence from 14th February and the forward contract will fall due on 14th April.
Date of delivery under forward contract will be:
Fixed and Options Forward Contracts
The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as fixed forward contract. For instance, if on 5th March a customer enters into a three months forward contract with his bank to sell GBP 10,000, it means the customer would be presenting a bill or any other instrument on 7th June to the bank for GBP 10,000. He cannot deliver foreign exchange prior to or later than the determined date.
We saw that forward exchange to a device by which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange exactly on the due date. In real situation, if is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents. Besides internal factors relating to production, many other external factors also decide the date on which he is able to complete shipment and present documents to the bank. At the most, the exporter can only estimate the probable date around which he would be able to complete his commitment.
With a view to eliminating the difficulty in fixing the exact date for delivery of foreign exchange, the customer may be given a choice of delivering the foreign exchange during a given period of days. An arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as ‘Option Forward Contract’. The rate of which the deal takes place is the option forward rate. For example, on 15th September a customer enters into two months forward sale contract with the bank with option over November. It means the customer can sell foreign exchange to the bank on any day between 1st November and 30th November. The period from 1st to 30th November is known as the ‘Option Period’.
Exchange Control Regulations
While booking forward contracts for customers, banks are required to observe that the exchange control regulations are complied with. Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000 govern forward exchange contract in India. The terms and conditions relate to booking, cancellation, rebooking etc. of forward exchange contracts are given below:
The operational aspects of the Forward Contract conditions are given below:
Booking of Forward Contracts
Calculation of Fixed Forward Rates
The method of calculation of forward rates is similar to that for ready rates. The only difference is that in the case of forward rates, the forward margin that is included in the rate will be for forward period as well. That is, the forward discount of the forward premium included in the buying rate will be not only for the transit period and usance, but also for the forward period. For instance, if the bank buys a 30 days sight bill for 2 months forward, the total forward discount will be for (30 days usance + 25 days transit +2 months forward, rounded off to higher month) 4 months.
For selling rates, forward margin is not considered while calculating ready rates. In the case of forward rates, the forward margin for the forward period will be included. In other respects, the calculation is same as that of ready rates.
The method of calculation of forward rates is shown below. For TT buying rate, forward margin will be included only for forward period.
Calculation option forward rates
Under an option forward contract the customer has the freedom to deliver the foreign exchange on any day during the option period. The bank should quote a single exchange rate valid for the entire option period.
Suppose that the following rates prevail for US dollar on 17th February:
Spot 49.45 49.50
Spot/March 0.05 0.06 pm
Spot/April 0.08 0.09 pm
Spot/May 0.11 0.19 pm
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