When computing exchange rates for merchant transactions, the cover or the base rate at which the cover transaction can be undertaken in the Forex market is first computed, thereafter the profit margin as allowed by the Foreign Exchange Dealer’s Association of India (FEDAI) is taken and the rate rounded off as per FEDAI Rule. In case of forward contracts, the procedure is similar except that while computing the base rate, the forward margin has to be appropriately taken.
The forward margin is the extent to which the forward rate for a currency differs from its spot rate against a second currency. The forward margin when it tends to make a currency cheaper is called a ‘Discount’ while if it makes it costlier it is called a ‘Premium.’ Obviously if one currency is getting cheaper in the forward against another, the second should be getting costlier against the first. Thus while the first currency would be said to be at a discount against the second, the second would be at a premium against the first.
Forward contracts for merchants generally provide for delivery within a specified period, with the merchant having the option of the date of delivery within the specified period. The period specified however, cannot be wider than a month. Merchant contracts generally run from the date after the date of contract in the month for which the cover has been booked.
It is however, possible for merchants to require shorter option periods or even fixed dates. The option period only enables the customer to provide for any uncertainty in the exact date of delivery. If the date is more precisely known, the merchant can definitely go in for shorter option periods or even fixed date contract.
Firstly, in computing the forward rate, the base rate has to be derived from the spot rate by adding or deducting the appropriate forward margin to reflect the premium or discount on the currency. For this it is necessary to select the appropriate forward exchange margin. Since the option period delivery is at the option of the customer, the bank would be very conservative and while charging or conceding the forward margin, expect the merchant delivery at the most adverse (to the bank) date. This is shown below in what is popularly known as “Holgate’s Rule”.
|Forward Purchase Contract||Presume earliest delivery||Presume latest delivery|
|Forward Sale Contract||Presume latest delivery||Presume earliest delivery|
These presumptions are obviously necessitated by the fact that the merchant has the option of choosing the date of delivery within the specified option period.
Forward quotes are generally obtained for the USD, which is the principal currency dealt in the local market. For arriving at forward rates for other currencies, the rate is derived by crossing the forward Rs/USD rate with the forward rate of the other currency against the USD, This sometimes results in two types of situations:
- When USD is at a premium against the rupee the other currency may be at a discount against the dollar. In such cases, a very conservative treatment would be to take premium for the latest delivery on the Rs/USD while conceding the discount for only the earliest delivery period for the other currency against the dollar in forward sale contracts. Conversely, for forward purchase contracts, taking the discount for the latest date for the currency in discount, while conceding the premium only up to the earliest date for the currency at a premium, will make the rate extremely unattractive for the customer. It is also basically illogical as it simultaneously presumes the earliest as well as the latest date delivery for the same transaction. It is preferable for the bank to calculate the cross rates for both, the earliest and latest delivery dates, and then choose the rate that is more protective to the bank.
- In the Indian inter-bank market, forward rates are generally quoted on the basis of calendar months. Thus we have forward delivery periods such as full month October, first half of November, last week September, etc. While in the overseas markets the forward rate is generally a fixed date from the spot date. Thus, two months forward contract booked on 16th August (Spot date 18th August) would be delivered on 18th October.
For instance, if forward sale contract is to be booked on 16th August for third month delivery for a premium currency, the bank would have to take the third month rate in the overseas market and cross it with rate for Rs/USD for the first half of November in the local market. If a quote is not available for the portions of the forward month, the bank can very conservatively charge the premium for the entire month of November. Generally, while forward prices may be available for portions of a month for nearer months, they may not be so easily available for the future months.
In forward sale contracts, the delivery refers to the actual cash flow, i.e. the date of sale of foreign currency to the customer. In case of forward purchase contracts, however, the delivery would refer to the tender by the merchant of a documentary bill in accordance with the underlying sale contract / Letter of Credit. The inflow of currency would be only on a future date determined by the transit time as also the tenor of the export bill. Consequently, the rate for forward purchase contract would be based on the forward rate appropriate not only to the delivery period but also the transit and usance period of the bill if any.
Generally banks would be very conservative in conceding the premium for the transit period. This is because the transit period of the export bill at the time of purchase of a documentary bill is only an estimate based on what has been prescribed by the FEDAI. The actual transit period could be much less or more. Hence, the conservative practice would be to take the forward margin for the transit period if the currency is at a discount but not concede it if the currency is at a premium. For large value transactions and when market premia are quite high, banks may at their discretion pass on some of the premium for the transit period.
Credit: International Finance-MGU MBA