Forward exchange is a device to protect traders against risk arising out of fluctuations in exchange rates. A trader, who has to make or receive payment in foreign currency at the end of a given period, may find at the time of payment or receipt that the foreign currency has appreciated or depreciated. If the currency moves down or gets depreciated the trader will be at a loss as he will get lesser units of home currency for a given amount of foreign currency, which he was holding. Similarly, an importer, who was contracted to make payment of a given amount in dollar at the end of a given period, may find that at the time of payment, the rupee dollar rate is higher. He would then have to pay more in rupees than what it would have been at the time when the contract was made.
To protect traders against such risks of appreciation and getting lesser amount of home currency, there is a device in foreign exchange market of booking forward exchange contracts. The emergence of forward exchange contracts has been due to the exchange rate fluctuations and possible losses that the traders might have to suffer in their foreign exchange business. The forward exchange transaction is an umbrella which gives protection to the dealers against the adverse movement of exchange rates. The forward exchange market in fact came into existence when the exchange rates were highly unstable following the abandonment of the gold standard by most of the countries at the end of first and Second World Wars. There are other means of taking care of the risks of the adverse effects of the exchange rate fluctuations such as including the Escalation Clause in the sale and purchase contracts entered between the buyers and sellers or fixing a parity rate between the home currency and foreign currency and any variation in the fixed parity entered into between the importers and exporters, the exchange risks will be passed on as per the terms of the contract. Escalation clause is more adaptable in contracts amounting to a very large volume,. especially in contracts entered into on deferred payment terms.
Forward Foreign Exchange Contracts
Under option forward exchange contracts, the customers has an option to receive or deliver the contract amount of foreign exchange on spot basis on any day during the month the where in the option falls. This option period is one calendar month and the customer has an option to call for or deliver the forward exchange on any day during 1st and the last day of the month for which the contract is booked. In option forward exchange, the delivery is not fixed but is adjusted to mature on any of the two dates or in between. Option forward contracts are very much in vogue due to uncertainty prevailing in the delivery schedules in the international market.
Option forward contracts in inter-bank markets are also booked for split delivery and the contracts are booked for delivery in first half or second half of the month. This means delivery of forward exchange will be made from 1st day of the month to the 15th day of the month and second half means that the delivery will be effected from 6th day of the month to the last day of the month, as requested.
The ordinary forward transaction requiring delivery on a specified date is often “fixed forward”, to the distinguish it from the forward option.
When the banker has to quote to a customer rates for a forward contract, he bases his quotation on the fixed forward rates. In an option contract the customer may demand completion of the contract on any day during the option period. For fixed forward contracts different rates will apply to different days of the period. For the option it will be the same rate for the whole period, and obviously it will be the rate which is most favorable the banker.
As an illustration, let us suppose the current quotation for dollar sterling in New York is:
- Spot £ 1 $ 216-218
- 1 month forward 3-2 c. discount
- 2 months forward 5-4 c. discount
- 3 months forward 8-6 c. discount
The outright quotations for fixed forward deals will be as follows:
|1 1month forward fixed||213$||216$|
|2 months forward fixed||211$||214$|
|3 months forward fixed||210$||212$|
Now, if a customer wants to buy forward sterling at its option during the following month, the banker undertakes to deliver him the dame at the agreed rate at any time during the month. Hence , the customer can pick up delivery of the dollars on the first or last day of the month or any intervening day. The banker is aware that he may have to deliver the sterling at the earliest, on the first day, and at the latest, at the end of the month, and these are the extremes of the option allowed to the customer, and the rates applicable to these dates will be considered by the banker in deciding what rate to quote for the transaction. The banker will quote the rate which is favorable to him.
On the basis of the rates given above , the bankers selling rate for spot will be $ 218 if the customer wants delivery ready, and $ 216 will be 1 month fixed forward rate, if delivery is demanded at the end of one month. For an option over the month the banker will quote the rate, which is more favorable to him, i.e., 218. If the option allowed is for the period over the second month, the rate quoted will be 216, the one month fixed forward rate, i.e., the rate applicable for delivery on the first day of the second month. For option over the third month the rate will be that applicable for delivery on the first day of the third month, i.e. 214. On the same principle, if a customer, who wants to sell sterling to the bank, wants an option over the first month, the rate quoted will be chosen from the bankers buying rates applicable to the first and the last day of the month, viz., $ 216 and 213. It will obviously be the one wherein the banker has to apart with less dollars per £, i.e., $ 213. Similarly, for a two month option over the second month, the rate will be the one applicable to the last day of the second month viz. 211. For a three month forward option or for option over the second and third months or for option only over the third month, the rate quoted will be the one applicable to the last day of the third months, viz., $ 210.
If sterling is at a premium the same principle will apply. Thus, if the market rates on a particular day are spot $ 216-218 and forward 1 month 2-3 c., 2 months 4-5 c., and 3 months 6-8 c. premium, the rates quoted on the day will be as under:
|1 1month forward fixed||213$||221$|
|2 months forward fixed||220$||223$|
|3 months forward fixed||222$||226$|
Factors responsible for premium and discount:
|Excess demand of forward currency||Excess supply of forward currency|
|Higher Rate of Interest in home center||Higher Rate of Interest in Foreign center|
|Likely Appreciation of Spot Rates||Likely depreciation of Spot Rates|
Credit: International Finance Notes- M.G.University