Fixed and Option Forward Contracts and it’s computation
Under the fixed forward contract the delivery of foreign exchange should take place on a specified future date. Then it is known as ‘fixed forward contract’. Suppose a customer enters into a three months forward contract on 5th January with his bank to sell Euro 15,000, then the customer would be presenting a bill or any other instrument on 7th April to the bank for Euro 15,000. The delivery of foreign exchange cannot take place prior to or later than the determined date.
Though forward exchange is a mechanism wherein the customer tries to over come the exchange risk, the purpose will be defeated if the delivery of foreign exchange does not take place exactly on the due date. Practically speaking, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents for reasons which are internal relating to production. 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. More often, what is possible for the exporter is only estimate the probable date around which he would be able to complete his commitment.
Under such circumstances, just to avoid the difficulty of 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. Such 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 at which the deal takes place is the option forward rate. For example, on 10th June a customer enters into two months forward sale contract with the bank with option over August. It means the customer can sell foreign exchange to the bank on any day between 1st August and 31st August In the example, the period during which the transaction takes place is known as the ‗Option Period‘.
Computation of Forward Exchange Rates
Fixed Forward Contracts: The method of calculation of forward rates is similar to that of ready rates discussed earlier. However, in the case of forward rates, the forward margin added will include the forward period as well besides the transit and usance period. While selling the forward margin is included only for the forward period.
Option Forward Contracts :In the case of 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 rate valid for the entire option period. The option rate quoted on behalf of the customer is based on the inter bank option forward rate, while between banks the option of delivery under a forward contract rests with the buying bank. To put it simply, the quotation under option delivery is as follows: for purchase transactions quote premium for the earliest delivery and for sale transactions quote premium for latest delivery.
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