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Forex forward contracts


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Published in: Business, Economy & Finance

Forex forward contracts

  1. 1. Foreign Exchange Forward Contracts By Tarun & Sindhu
  2. 2. Trailer• Hedging and its importance• Terms used in Foreign Exchange Market• Meaning of Foreign Exchange Forward Contract• Characteristics• When Foreign Exchange Forward Contract?• Closing of Forward Contracts• Foreign Exchange Forward Contracts and Accounting Standards• Evidence for use of Hedging in India
  3. 3. HEDGING AND ITS IMPORTANCE• Hedging means reducing or controlling risk.• Risk includes transaction risk, translation risk, economic risk and political risk.• So in case of a forward contract, we would be fixing the forward rate which would hedge the position in the future.
  4. 4. Terms used in Foreign Exchange Market1. Bid Rate – The rate at which the bank buys a currency.2. Ask rate – The rate at which the bank sells a currency. If a Banker provides the following quote – Rs/$ 45 – 48, 45 48 Bid rate Ask rate
  5. 5. Terms used in Foreign Exchange Market1. Spread – Difference between Bid rate and Ask rate.2. Spot rate – The rate quoted in current scenario.3. Forward rate – The rate contracted today for exchange of currencies at a specified future date.
  6. 6. Meaning of Foreign Exchange Forward Contract Foreign Exchange Forward Contract Performance at a Exchange of future date at Foreign Currency forward rates
  7. 7. Characteristics It is a contract for the purchase or sale of a specified quantity of a specified currency. Price is agreed today. Performance is at a specified future date. Both parties are obliged to perform. The party that buys the specified currency is said to have a long position. The party that sells the specified currency is said to have a short position.
  8. 8. Other Relevant Points There are 3 standard periods of time in a forward market i.e., 1 month, 3 month and 6 month forward. The length of time upto which one can stretch forward depends upon demand levels. In India, forward rates are available for 6-month periods and can be rolled over.
  9. 9. Should you take a Forward Cover? Deciding whether to take a forward cover or not depends on the type of person. In other words we need to see whether the person is an importer or an exporter. Another important thing of concern is that the banker ALWAYS WINS. Also it depends upon the relationship between the forward rate and expected spot rate.
  10. 10. Consider the following example: Exporter: You are going to receive 1,00,000 USD 3-months from today. You fear that the ` will appreciate against $ and hence, you may receive less ` 3-months later. So you enter into a forward contract and freeze the proceeds. What should you do? Importer: You are going to pay 1,00,000 USD 3-months from today. You fear that the ` will depreciate against $ and hence, you may pay more ` 3-months later. So you enter into a forward contract and freeze the payments. What should you do? >> You should prefer that option which gives you high inflow in the case of exporter and lower outflow in the case of imports.
  11. 11. Selection criteria for forward contract Relationship Exporter ImporterForward Rate > Expected Forward Cover Exposed Spot RateForward Rate < Expected Exposed Forward Cover Spot Rate
  12. 12. How to Close a Forward Contract?A Forward Contract can be closed either: On the due date of settlement of the forward contract (OR) On any date prior to the date of settlement. Roll Over Honor Cancel Closing out can be done in three ways:
  13. 13. Honoring a Contract Honoring a contract means performing the contract entered into at the end of the stipulated time period. Importer Exporter Sell the Foreign Buy the Foreign Currency on Currency on agreed date and agreed date and rate rate So further no action would be required other than the above.
  14. 14. • Sometimes the importer or exporter decides for an early honor.Early Honor • In such a case, following procedure needs to be followed: Early Honor Spot Forward Importer Buy Sell Exporter Sell Buy
  15. 15. Rolling over the Contract It means extending the period of the contract either on or before the due date.On Due Date: Roll Over on Due Spot Forward date Importer Sell Buy Exporter Buy Sell
  16. 16. Continued….• Before Due Date: Early Roll Over Forward Forward Importer Sell Buy Exporter Buy Sell
  17. 17. Cancel the Contract Cancelling a forward contract means revoking the performance. This would be done by taking an opposite position.• On Due Date: On Due Date Spot Importer Sell Exporter Buy
  18. 18. Continued…• Cancel Early: Cancel Early Forward Importer Sell Exporter Buy
  19. 19. FOREIGN EXCHANGE FORWARDCONTRACTS AND ACCOUNTINGSTANDARDS Foreign Exchange Forward Contracts For Hedging For Trading or Speculation
  20. 20. As per Para 37 of AS-11, Any risk associated with changes in exchangerates may be mitigated by entering into forward exchange contracts. Two things arise in such contracts Premium or Exchange Discount Difference Amortized to P & L Written off to P & L Account over the Account as and contract period when it arises
  21. 21. Continued… Premium or Discount  = Difference b/w exchange rate on date of inception and forward rate as per contract. Exchange Difference  = Difference b/w exchange rate on reporting date and rate on date of inception.Consider the following example:Mr.A imports a plant worth 1,00,000 $ from USA on 01.06.2008.Payment to be made after 2 months. He enters into a 2-monthsforward contract on 01.06.2008.Forward rate booked – Rs.45.40Exchange rate on 1.6.2008 – Rs.45Exchange rate on 30.6.2008 – Rs.46Exchange rate on 31.7.2008 – Rs.47.50
  22. 22. Forward ExchangePremium Difference 45.40 - 45 47.50 - 45 Deferred Revenue Gain Expenditure Amortized over 2- Credited to P & L months i.e., at the Account on end of every month 31.07.2008
  23. 23. Date Particulars Amt (in Rs Lakhs) Amt (in Rs Lakhs)01.06.2008 Purchase A/c Dr 45 To Mr.X 45 (Being purchase of goods)01.06.2008 Forward Contract Receivable Dr 45 Deferred Premium Dr 0.4 45.4 To Forward Contract Payable (Being forward exchange contract entered into)30.06.2008 Difference in Exchange Dr 1 To Mr.X 1 (Being exchange loss on foreign currency creditors)30.06.2008 Forward Contract Receivable Dr 1 To Exchange Gain 1 (Being booking of exchange gain on forward exchange contract)30.06.2008 Profit & Loss A/c Dr 1.2 To Deferred Premium 0.2 To Difference in Exchange 1.0 (Being loss transferred to P & L A/c)30.06.2008 Exchange Gain Dr 1 To Profit & Loss A/c 1 (Being gain transferred to P & L A/c)31.07.2008 Forward Contract Receivable Dr 1.5 To Exchange Gain 1.5 (Being gain on forward contract)31.07.2008 Difference in Exchange Dr 1.5 To Mr.X 1.5 (Being exchange on settlement date)31.07.2008 Forward Contract Payable Dr 45.4 To Bank A/c 45.4 (Being payment made to bank on settlement date)31.07.2008 Mr.X A/c Dr 47.5 To Forward Contract Receivable 47.5
  24. 24. Forex Forward Contracts for Trading or Speculation When foreign exchange contracts are entered to earn profit by trading or speculation, the accounting treatment shall be different since the object is to gain rather than hedging. As per Para 39 of AS-11, premium or discount on such forwards need not be recognised. It means that the value of contract is marked to its current market value.
  25. 25. Outstanding Foreign Exchange Contracts of Banks Outstanding Foreign Exchange Contracts of banks (In Billions)SL Item March 2007 March 2008 March 2009 December 2009No INR USD INR USD INR USD INR USD Foreign1 exchange 29,254 671.12 55,057 1,377.46 50,684 994.78 36,142 774.25 contracts Forward forex2 24,653 565.57 47,360 1,184.89 44,669 876.72 31,190 668.17 contracts
  26. 26. Advantages Certainty - secure income or stabilize cost Protection Cash flow modification Maximizing Share Holder Value
  27. 27. Disadvantages While forward contracts can fix anticipated revenue or cost, they cannot minimize cost or maximize revenue. Fixed Rate. Performance. Liquidity.  Tailor-made contracts-often suffer from poor liquidity.