Foreign Exchange Forward ContractsBy Tarun & Sindhu

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

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.

Terms used in Foreign Exchange Market

1. 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

Terms used in Foreign Exchange Market

1. 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.

Meaning of Foreign Exchange Forward Contract

Foreign Exchange

Exchange of Foreign Currency

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.

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.

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.

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.

Selection criteria for forward contract

Relationship Exporter Importer

Forward Rate > Expected Spot Rate

Forward Cover Exposed

Forward Rate < Expected Spot Rate

Exposed Forward Cover

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.

Closing out can be done

in three ways:

HonorRoll OverCancel

Honoring a Contract

Honoring a contract means performing the contract entered into at the end of the stipulated time period.

Importer Exporter

So further no action would be required other than the above.

Buy the Foreign Currency on agreed date and rate

Sell the Foreign Currency on agreed date and rate

Early Honor

• Sometimes the importer or exporter decides for an early honor.

• In such a case, following procedure needs to be followed:

Early Honor Spot Forward

Importer Buy Sell

Exporter Sell Buy

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 date

Spot Forward

Importer Sell Buy

Exporter Buy Sell

Continued….•Before Due Date:

Early Roll Over Forward Forward

Importer Sell Buy

Exporter Buy Sell

Cancel the ContractCancelling 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

Continued…•Cancel Early:

Cancel Early Forward

Importer Sell

Exporter Buy

FOREIGN EXCHANGE FORWARD CONTRACTS AND ACCOUNTING STANDARDS

Foreign Exchange Forward Contracts

For Hedging For Trading or Speculation

Two things arise in such contracts

Premium or Discount

Amortized to P & L Account over the contract period

Exchange Difference

Written off to P & L Account as and

when it arises

As per Para 37 of AS-11, Any risk associated with changes in exchange rates may be mitigated by entering into forward exchange contracts.

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-months forward 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

45.40 - 45

Deferred Revenue Expenditure

Amortized over 2-months i.e., at the end of every month

Forward Premiu

m

47.50 - 45

Gain

Credited to P & L Account on 31.07.2008

Exchange

Difference

Date Particulars Amt (in Rs Lakhs) Amt (in Rs Lakhs)01.06.2008 Purchase A/c Dr

To Mr.X(Being purchase of goods)

4545

01.06.2008 Forward Contract Receivable DrDeferred Premium Dr To Forward Contract Payable(Being forward exchange contract entered into)

450.4 45.4

30.06.2008 Difference in Exchange Dr To Mr.X(Being exchange loss on foreign currency creditors)

11

30.06.2008 Forward Contract Receivable Dr To Exchange Gain(Being booking of exchange gain on forward exchange contract)

11

30.06.2008 Profit & Loss A/c Dr To Deferred Premium To Difference in Exchange(Being loss transferred to P & L A/c)

1.20.21.0

30.06.2008 Exchange Gain Dr To Profit & Loss A/c(Being gain transferred to P & L A/c)

11

31.07.2008 Forward Contract Receivable Dr To Exchange Gain(Being gain on forward contract)

1.51.5

31.07.2008 Difference in Exchange Dr To Mr.X(Being exchange on settlement date)

1.51.5

31.07.2008 Forward Contract Payable Dr To Bank A/c(Being payment made to bank on settlement date)

45.445.4

31.07.2008 Mr.X A/c Dr To Forward Contract Receivable(Being USD paid to X)

47.547.5

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.

Outstanding Foreign Exchange Contracts of Banks

Outstanding Foreign Exchange Contracts of banks (In Billions)

SLNo

Item March 2007 March 2008 March 2009 December 2009

INR USD INR USD INR USD INR USD

1Foreign

exchange contracts

29,254 671.12 55,057 1,377.46 50,684 994.78 36,142 774.25

2 Forward forex contracts 24,653 565.57 47,360 1,184.89 44,669 876.72 31,190 668.17

Advantages

Certainty - secure income or stabilize cost

Protection

Cash flow modification

Maximizing Share Holder Value

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.

Thank You