Execution of Forward Contracts in Foreign Exchange Markets

A customer under forward exchange contract knows in advance the time and amount of foreign exchange to be delivered and the customer is bound by this agreement. There should not be any variation and on the due date of the forward contract the customer will either deliver or take delivery of the fixed sum of foreign exchange agreed upon. But, in practice, quite often the delivery under a forward contract may take place before or after the due date, or delivery of foreign exchange may not take place at all. The bank generally agrees to these variations provided the customer agrees to bear the loss, if any, that the bank may have to sustain on account of the variation.

Though the delivery or take delivery of a fixed sum of foreign exchange under a forward contract has to take place at the agreed time, quite often this does not happen and it may either take place before or after the due date agreed upon. However, the bank generally agrees to these variations provided the customer bears the loss if any on account of this variation.

Based on the circumstances, the customer may end up in any of the following ways:

  1. Delivery on the due date.
  2. Early delivery.
  3. Late delivery.
  4. Cancellation on the due date.
  5. Early cancellation.
  6. Late cancellation.
  7. Extension on the due date.
  8. Early extension.
  9. Late extension.

As per the Rule 8 of FEDAI, a request for delivery or cancellation or extension of the forward contract should be made by the customer on or before its maturity date. Otherwise a forward contract which remains unutilized after the due date becomes an overdue contract. Rule 8 of FEDAI stipulates that banks shall levy a minimum charge of Rs. 100 for every request from a merchant for early delivery, extension or cancellation of a forward contract. This is in addition to recovery of actual loss incurred by the bank caused by these changes.

Delivery on Due Date: This is the situation envisaged when the forward contract was entered into. When the foreign exchange is delivered on the due date, the rate applied for the transaction would be the rate originally agreed, irrespective of the spot rate prevailing.

Early Delivery : When a customer requests early delivery of a forward contract, i.e., delivery before its due date, the bank may accede to the request provided the customer agrees to bear the loss, if any, that may accrue to the bank.

Cancellation/Extension of forward contract: The customer is having the right to cancel a forward contract at any time during the currency of the contract. The cancellation is governed by Rule 8 of the FEDAI. The difference between the contracted rate and the rate at which the cancellation is done shall be recovered or paid to the customer, if the cancellation is at the request of the customer. Exchange difference not exceeding Rs.50 shall be ignored. The spot rate is to be applied for cancellation of the forward contract on due date. The forward rate is to be applied for cancellation before due date. In the absence of any instruction from the customer, contracts which have matured shall on the 15th day from the date of maturity be automatically cancelled. If the 15th day falls on a holiday or Saturday the cancellation will be done on the next succeeding working day. The customer is liable for recovery of cancellation charges and in no case the gain is passed on to the customer since the cancellation is done on account of customer‘s default. The customer may approach the bank for cancellation when the underlying transaction becomes infractions, or for any other reason he wishes not to execute the forward contract. If the underlying transaction is likely to take place on a day subsequent to the maturity of the forward contract already booked, he may seek extension in the due date of the contract. Such requests for cancellations or extension can be made by the customer on or before the maturity of the forward contract.

Cancellation of Forward Contract on Due date: When a forward purchase contract is cancelled on the due date it is taken that the bank purchases at the rate originally agreed and sells the same back to the customer at the ready TT rate. The difference between these two rates is recovered from/paid to the customer. If the purchase rate under the original forward contract is higher than the ready T.T selling rate the difference is payable to the customer. If it is lower, the difference is recoverable from the customer. The amounts involved in purchase and sale of foreign currency are not passed through the customer‘s account. Only the difference is recovered/paid by way of debit/credit to the customer‘s account. In the same way when a forward sale contract is cancelled it is treated as if the bank sells at the rate originally agreed and buys back at the ready T.T buying rate. The difference between these two rates is recovered from/paid to the customer.

Early Cancellation of a Forward Contract: Sometimes the request for cancellation of a forward purchase contract may come from a customer before the due date. When such requests come from the customer, it would be cancelled at the forward selling rate prevailing on the date of cancellation, the due date of this sale contract to synchronize with the due date of the original forward purchase contract. On the other hand if a forward sale contract is cancelled earlier than the due date, cancellation would be done at the forward purchase rate prevailing on that day with due date of the original forward sale contract.

Extension on Due date: An exporter finds that he is not able to export on the due date but expects to do so in about two months. An importer is unable to pay on the due date but is confident of making payment a month later. In both these cases they may approach their bank with whom they have entered into forward contracts to postpone the due date of the contract. Such postponement of the date of delivery under a forward contract is known as the extension of forward contract. The earlier practice was to extend the contract at the original rate quoted to the customer and recover from him charges for extension. The reserve bank has directed that, with effect from16.1.95 when a forward contract is sought to be extended, it shall be cancelled and rebooked for the new delivery period at the prevailing exchange rates. FEDAI has clarified that it would not be necessary to load exchange margins when both the cancellation and re-booking of forwards contracts are undertaken simultaneously. However it is observed that banks do include margin for cancellation and rebooking as in any other case. Further only a flat charge of Rs.100 (minimum) should be recovered and not Rs.250 as in the case of booking a new contract.

Overdue Forward Contracts: As we have already seen, the customer has the right to utilize or cancel or extend the forward contract on or before its due date. No such right exists after the expiry of the contract. FEDAI Rule 8 provides that a forward contract which remains overdue with any instructions from the customer concerned on or before its due date shall on the 15th day from the date of maturity be automatically cancelled by the bank. The customer remains liable for the exchange difference arising there from but if it results in profit it need not be passed on to the customer. In case of delivery subsequent to automatic cancellation the appropriate current rate prevailing on such delivery shall be applied.

Roll over Forward Contracts: When deferred payment transactions of imports/exports takes place, the repayment of the installment and interests on foreign currency loans by the customer requires long term forward cover where the period extends beyond six months. The bank may enter into forward contract for long terms provided there is suitable cover is available in the market. However the cover is made available on roll over basis in which cases the initial contract may be made for a period of six months and subsequently each deferred installments for the outstanding balance of forward contract by extending for further periods of six months each. For these transactions the rules and charges for cancellation / extension of long term forward contracts are similar to those of other forward contracts.

Interbank Deals: Foreign exchange transactions involves transaction by a customer with the bank while interbank deals refer to purchase and sale of foreign exchange between banks. In other words, it refers to the foreign exchange dealings of a bank in interbank market.

Cover Deals: The banks deal with foreign exchange on behalf of its customers. Purchase and sale of foreign currency in the market undertaken to acquire or dispose of foreign exchange required or acquired as a consequence of its dealings with its customers is known as the ‗cover deal‘. In this way that is through cover deal the bank gets insured against any fluctuation in the exchange rates.  While quoting a rate to the customer the bank is guided by interbank rate to which it adds or deducts its margin, and arrives at the rate it quotes to the customer. For example, if it is buying dollar from the customer special it takes interbank buying rate, deducts its exchange margin and quotes the rate. This exercise is done on the assumption that immediately on purchase from customer the bank would sell the foreign exchange to interbank market at market buying rate.

Foreign currency is considered as peculiar commodity with wide fluctuations price, the bank would like to sell immediately whatever it purchases and whenever it sells, it immediately tries to purchase so that it meets it is commitment. The main reason for this is that the bank wants to reduce exchange risk it faces to the minimum. Otherwise, any adverse change in the rate would affect its profits.  In the case of spot deals the transaction is quite simple. If the bank purchased any foreign exchange, it would try to find another customer to whom it can sell this and thus books profit. In this process the profit would be the maximum because both buying and selling rates are determined by the bank and the margin between the rates is the maximum. If it cannot find another customer its sells in interbank market where the rate is determined by the market conditions and the margin is narrower here.

Trading: Trading refers to purchase and sale of foreign exchange in the market other than to cover bank‘s transactions with the customers. The purpose may be to gain on the expected changes in exchange rates. In India the scope for trading, although still subject to controls, is getting wider the relaxations being made in the exchange control regulations.