Meaning of Currency Forward Contract
Currency Forward Contract is an instrument that can be used for hedging the exposure in foreign currencies. Under this contract customer enter into a contract with the bank to fix the exchange rate of a foreign currency for purchase or sale on a specified date in future.
The fixed rate for a currency forward contract is derived by adjusting the spot foreign exchange rate by swap points or forward differential. Swap points or forward differential shows the interest rate differential of two currencies.
FORWARD RATE= SPOT RATE (+ 0r -) INTEREST DIFFERENTIAL OF TWO CURRENCIES (SWAP POINTS)
SWAP POINTS= FORWARD RATE – SPOT RATE
Swap Points-Positive– It means base currency is on premium
Swap Points-Negative– It means base currency is on discount
Swap Points- Zero– It means Spot Rate= Forward Rate
Annualised Premium or Discount Calculation= (FR-SR)/SR*(12/n) *100
Generally, Currency forward contract does not involve any initial payment such as margins in case of currency future contracts and premium in case of currency option contracts.
However, banks or financial institution that deal in currency forward contract, to secure the execution of contract on specified date and to discourage the attempt of walk away from the contract, may require a security deposit from retail investors or small firm with whom they don’t have business relationship.
Currency forward is an over-the-counter (OTC) derivative contract. Being an Over-The-Counter derivative product, it’s not standardized and have more risk as compare to currency future contracts. Currency forward contracts are also called Outright Forward Contracts.
These contracts are not traded on exchanges.
Let’s see an example for better understanding.
There is an importer who is in requirement to pay 10,000 US$ after the period of 1 year for a consignment. Current spot rate is 1USD = INR 70. Interest rate in USA is 5% where as in India the interest rate is 8%. Importer approaches the bank for forward contract. Find out what would be the forward rate?
Value of US $ after one year = 1 plus interest rate of 5% = 1.05
Value of Indian Rupee after one year = INR 70 plus 8% = 75.60
Based on interest rate parity after 1 year forward rate – 1.05$ = INR 75.60
Or 1$ = INR 72
Hedging Using Currency Forward
Currency forward contracts help in hedging exposure of foreign currency. By entering into this contract exchange rate can be fixed on a specified future date.
For example, Mr. ‘A’ is an importer and he imported goods from USA of 10,000 US$ and he required to pay the proceeds of this transaction on completion of 1 year from now. Importer is concerned that the price of US$ may increase from its current price that is 1$ = INR 70 a year from now. That means Mr. ‘A’ has to pay more Rupees as compare to current scenario. To eliminate such concern Mr. ‘A’ entered into forward contract with his bank to buy 10,000 US $ at the forward rate of 1US$ = INR 73.
If, a year from now, exchange rate is 1USD = INR 75, that means price of $ has been increased and importer by entering into forward contract saved INR 20,000 [10,000$ * (75 – 73)]. On the other hand, if the exchange rate a year from now is 1USD = INR 71 then importer will bear loss of INR 20,000 [10,000$ * (73 – 71)]. If you will focus on second case where exchange rate is in favour of importer but he cant’s avail that benefit. This is a big disadvantage of currency forward that favourable exchange rate benefits are lost.
Important Terms of Currency Forward Contract
Early Delivery in Currency Forward Contract
You know very well that currency forward contracts are entered to exchange foreign currency on a specified date in future. But it might happen that in future due to some circumstance’s customer may approach the bank before the specified date for the execution of contract.
Execution of currency forward contract before the specified date is called Early Delivery.
Cancellation of Currency Forward Contract
If due to some uncertain events or reasons, if forward contract can not be executed then it is cancelled. There are so many events that may cause cancellation of contract and one of them is Extension or Rollover.
Remember in market, to nullify a position, you have to create opposite position. Like if you are in buying position then you have to sell and if you are in selling position then you have to buy.
Extension or Rollover of Currency Forward Contract
Some times may be due to some unforeseen reasons, payment or receipt of foreign currency is required to be deferred. In such cases banks may be requested to extend the date of forward contract.
Extension of contract will require cancellation of existing contract and fresh booking of new contract.
If such cancellation involves any gain then that will be transferred to customer and if cancellation involves any cost then that will be recovered from customer.
Rollover is just like Extension. Under Rollover part amount is settled on due date and part amount is extended for settlement to new date in future.