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Forward contracts simplified
By C.E.S Azariah,
CEO, FIMMDA
Following slides illustrate Forward Contract
pricing for USD/INR for Exporters by
Banks
Foreign
Buyer
Exporter
Order/LC
For T-Shirts
Shipment after 1 –year.
Price $ 10 per T-shirt
Exporters P/L calculations : T-Shirt Cost = Rs 380 + Profit Rs 10
Export Invoice Price
: Rs 390
Exchange Rate as on April 2007 $ 1
= Rs 39.00
Therefore USD Price per T-Shirt
: $ 10
EXPORTER’S DILEMMA
If after 1 year:
Exchange Rate of 1 USD = Rs 29.00
Exporter gets USD 10.00 x 29.00 = Rs 290
per T.Shirt
Cost of T-Shirt
= Rs 380
Loss per T- shirt
= Rs 90
If after 1 year :
Exchange Rate of 1 USD = Rs 49.00
Exporter gets USD 10.00 x 49.00 = Rs 490
per T- Shirt
Cost of T-Shirt
= Rs 380
Profit per T-Shirt
= Rs 110
EXPORTER’S DECISION
• I am in the business of manufacturing T-Shirts, and I
am satisfied with my profit margin of Rs 10/= per
T-Shirt.
• I need a protection from business losses due to USD
Exchange Rate fluctuations.
EXPORTER APPROACHES HIS BANK
• Request the Banker for a Quote (RFQ) for getting an
Exchange Rate for USD valid as on 1 year hence
(forward rate).
• Exporter undertakes to deliver X amount of USD ,
being the invoice amount of his T-Shirt exports, to
the bank, one year hence, once his export of goods is
completed, invoiced, and USD remittance received
from foreign buyer.
BANKER’S DILEMMA
• The Exporter is asking Rupees (one year hence) in
exchange for USD, which the Exporter will deliver after 1
year .
• The Banker can get Rupees to deliver to the Exporter, only
if he sell the USD (acquired from the exporter) in the
market.
• If the Exchange Rate of USD vs Rs remains fixed, for one
year, it will be very easy for the Banker to quote a rate, but
then, the Exporter’s Dilemma would not arise !
• The Exchange Rate fluctuations , therefore, create a
“Dilemma” for both the Exporter and the Banker !
BANKER IS FACED WITH SIMILAR
DILEMMA AS THE EXPORTER
If the Banker quotes today’s Exchange Rate plus his
profit i.e.:
1 USD= Rs 39.00 less Rs 0.05 = Rs 38.95 (contracted
rate)
(principle of Take More, Give Less),
I . After 1 year :
If 1 USD = Rs 29.00
Bank delivers
………….. Rs 38.95 (contracted rate)
Bank receives ……………. Rs 29.00 ( by selling the
USD acquired from the Exporter after 1 year)
Loss per USD
= Rs 9.95.
II After 1 year :
If 1 USD = Rs 49.00
Bank delivers ……………..Rs 38.95 to Exporter at
Contracted Rate
Rank received …………. Rs 49.00 (by selling the
USD acquired from the exporter )
Profit per USD ………….RS 10.05
BANKER’S DECISION
• I am in the business of banking (borrowing and
lending), and buying and selling financial products.
• I am satisfied with my profit margins of ___ %, and
cannot afford unexpected losses.
• I will use my expertise in borrowing and lending,
purchase and sale of foreign currencies vs Indian
Rupees to deliver what the Exporter wants
1
2
Borrow
Sell
$ 9.50
Bank
X
Bank
A
$ 9.50
Rs
370.50
Bank
Y
4
Receive Maturity
Proceeds
Rs 392.50 (Int.5.94
%)
3
Deposit/Lend
Rs 370.50
Bank
Z
Forward
Exchange Rate
1$ = Rs 39. 20
Exporter
Spot Exchange rate
1$ = Rs 39.00
10 $
Bill
1
Borrow
$ 9.50
Bank
X
6
5
Rs 392.00 ( 392.50- 0.50)
2
Sell
$ 9.50
RS 370.50
Bank
A
Repay $
10.00 ( Loan
+ Int)
3
Lend/Deposit
Rs 370.50
4
Receive maturity
Proceeds including
Int Rs 392.50
Bank
Z
Bank
Y
3 MONTHS LATER
(Cancellation of Contract before due date)
If Spot $/INR = Rs 29.00 (say)
• After the Exporter booking a Forward Contract at 1$ = Rs
39.20 (value 1 year Fwd)
• Foreign Buyer cancels the order placed with the Exporter
Exporter
Request to cancel Forward Contract
Bank
A
Exporter
Rs 87.50 ( Gain to Exporter
without making any Exports ! )
4
Bank
X
3
Prepay $9.50+
Int$0.10 = $ 9.60
2
Bank
A
Break
deposit
1
Buy
$ 9.60
Bank
Y
Rs
278.40
Rs370.50+ Int
(5.40)=375.90
Spot Exch
Rate :
1$=Rs 29.00
Gain on Cancellation of Fwd Contract: Rs 375.9- Rs 278.4 = Rs 97.50 1
Bank
Z
Less Interest on $ loan converted into Rs
Less Bank A’s operating Expenses + margin
Amount payable to Exporter
= Rs 03.50
Rs 06.50
Rs 87.50
3 MONTHS LATER
(Cancellation of Contract before due date)
If Spot $/INR = Rs 49.00 (say)
• After the Exporter booking a Forward Contract at 1$ = Rs
39.20 (value 1 year Fwd)
• Foreign Buyer cancels the order placed with the Exporter
Exporter
Re quest to cancel Forward Contract
Bank
A
Exporter
4
Bank
X
3
Prepay $ loan +
Int =$ 9.60
Break
deposit
Rs 104.50 ( Loss to Exporter)
Bank
A
Buy
$ 9.60
2
Bank
Y
Rs 470.40
1
Rs+ Int ( 375.9)
Spot Exch
Rate :
1$=Rs 49.00
1
Loss on Cancellation of Fwd Contract: Rs 375.9- Rs 470.4= Rs (94.50)
Add Interest on $ loan converted into Rs
=Rs (3.50)
Add Bank A’s operating Expenses + margin
Rs (6.50)
Amount Payable by the Exporter
Rs (104.50)
Bank
Z
ON DUE DATE
I. If 1 USD = Rs 49.00
(a) Does the Banker make a profit of Rs 9.80
Contracted Rate with Exporter:
1 USD= Rs 39.20
Exchange Rate on Due Date 1 USD=Rs 49.00
Rs 9.80
Obviously NO – because the Banker repays the loan
of USD 9.50 + Interest with the USD received from
the Exporter .
On due date (contd)
(b) Does the Exporter make a loss of 9.80 ?
The Exporter’s Decision was to protect his business
profit of Rs 10.00, which he has done by delivering
the USD at the contracted rate of 1 USD= Rs 39.20.
The Exporter suffers an “Opportunity Loss” by
protecting himself against all Exchange Rate
fluctuations.
On due date (contd)
II . If 1 USD = Rs. 29.00
(a) Does the Banker lose Rs. 10.20 by taking delivery of the USD at
contracted rate of 1USD= Rs 39.20 ?
Contracted Rate
Market Rate on due date
1 USD = Rs. 39.20
1 USD = Rs 29.00
Rs 10.20
Obviously NO – because there is no sale of USD on due date.
The Banker sold the USD on the contract date at 1 USD = Rs 39.00.
The dollar received from the exporter goes towards liquidating the
USD borrowed.
On due date (contd)
II (b) Does the Exporter gain Rs 10.20 by delivering
the USD at contracted rate of 1USD = RS 39.20,
when the market rate is Rs 29.00 on due date ?
Obviously NO – because on the contract date itself
the Exporter locked the rate at which he would sell
the USD to the bankers on the due date.
The Exporter has protected himself against the
adverse movement of the USD
On Due Date (contd)
• I. What happens if the Exporter does not have the
dollars to deliver on the Due Date, and asks the
Banker to cancel the contract ?
• The results would be the same as the scenarios
shown for cancellation of contracts after 3 months
.
• If the USD rate is lower than contracted rate, the
Exporter receives some money on cancellation .
Why ?
• If USD rate on due date is higher than contracted
rate, the Exporter has to pay the cost incurred by
the banker on cancelling the contract. Why ?