Forward Contract - A Hedging Instrument A forward contract is normally entered into to hedge oneself against exchange risk ie the

uncertainity regarding the future movements of the exchange rate. By entering into a forward contract the customer locks-in the exchange rate at which he will buy or sell the currency Discount and Premium A currency is said to be at premium against another currency if it is more expensive in the forward market than in the spot market. In this case, its forward rate will be higher than its spot rate. This happens when the future spot rate is expected to be higher than the current spot rate. Conversely, a currency is said to be at a discount if it is cheaper in the forward market than in the spot market. In this case, its forward rate will be lower than its spot rate. This happens when the future spot rate is expected to be lower than the current spot rate. Let us assume the following USD/INR quotes USD/INR Spot :: 40.50/51 USD/INR 3 Months :: 40.76/78 Here the bank is ready to give only 40.50 currently in exchange for a dollar, while it is ready to give 40.76 after 3 months. So the dollar is expected to be more expensive in the future and hence is at a premium against the rupee. Swap Points The difference between the spot rates and the forward rates can be expressed in terms of swap points. In the above example the swap point will be 26/27 ie (40.7640.50/40.78-40.51). When the swap points are low/high (as in the Dollar-Rupee example given above). Calculation of Forward Rates The method of calculation of forward rates is tabulated below. We will consider USD/INR forward calculation for the time. Forward Buying Rate Dollar/ Rupee Market Spot Buying Rate :: 40.50 Add : Forward Premium (For forward period, transit period and usance period, round off to lower months) OR Less : Forward Discount (For forward period, transit period, transit period and usance

period, rounded off to higher months) Thus give the Forward Buying Rate for USD/INR

Forward Selling Rate Dollar/ Rupee Market Spot Selling Rate :: Rs. 40.52 Add Forward premium for forward period OR Less Forward discount for forward period Thus arrives the Forward Selling Rate for USD/INR

Example : One of the export customer requests you on 15th July to book a Forward Contract delivery September for USD 1000000. Assuming the dollars are quoted in the local interbank market as under Spot USD/INR :: 40.5100/5200 Spot/July :: 0300/0400 Spot/August :: 0800/0900 Spot/September :: 1300/1400 Spot/October :: 1800/1900 Spot/Novemebr :: 2300/2400 What rate will the customer get from the bank. Solution : Dollar is at premium. The rule is to take the earliest delivery. The option to the cutomer is over September. Taking earliest delivery, the date of delivery will be taken as 1st September. As the bank will consider the earliest delivery of the commodity ie USD the customer rate will be based on Spot/September. Calculation : Dollar/Rupee Spot :: 40.5100 Add forward premia for Sep Deliv :: 0.1300 Total :: 40.6400 (Here the customer should consider the margins charged by banks. That will differ from bank to bank as there is no strict rule on exchange margins as of now) Less exchange margin(charged by bank) :: 0.0500 Rate quoted to the Customer would be :: 40.5900 Problem for Practice :: One of export cutomer requests you on 4th April to book a forward contract for USD 100000 for delivery June. Assuming the dollars are quoted in the local interbank market as under Spot USD/INR :: 43.5100/5200 Spot/April :: 0300/0400

Spot/May :: 0800/0900 Spot/June :: 1300/1400 Spot/July :: 1800/1900

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