Forward Contracts

Tasneem Chherawala
NIBM, 2016

Forward Contract
A bilateral contract between two parties in which one party agrees to buy and the other party
agrees to sell a pre-specified amount (Notional Amount) of an underlying asset at a prespecified future date at a pre-specified price.
Both parties to the contract have both the right and the obligation to settle the deal as per
the specified terms
The current date on which the Forward Contract is originated is the Deal Date (Trade Date)
The pre-specified future date is typically the Maturity / Expiry Date of the Forward Contract.
The pre-specified price is the Delivery Price / Forward Price.

Forward Contract: Positions

Cash (Delivery Price)

The Forward Contract creates simultaneously a long and

short position for the two counterparties
Long Position in Forward Contract
Will buy the underlying asset at the specified future date at the
delivery price

Short Position in Forward Contract

Will sell the underlying asset at the specified future date at the
delivery price

Forward Contract: Pay-offs at

Maturity
Depending on the spot price of the asset
on the date of maturity, the delivery price
in the contract, and the position in the
forward, each counterparty to the contract
makes either a gain or a loss on the
contract on maturity date

Forward Contract: Pay-offs at

Maturity
Long Position in Forward Contract

Forward
contract
Long
Position
Payoff

Short Position in Forward Contract

gain

gain

Forward
contract Payoff to
seller
0

Delivery
Price

loss

Spot Price
At Maturity

Delivery
Price

loss

Spot Price
At Maturity

Forward Contracts: Payoffs at

Maturity
The payoff from a long position in a forward contract on
one unit of an asset is given by

( ST F ) xN
Where K is the delivery price and ST is the spot price of
the asset at maturity of the contract and N is the Notional
Amount of the asset
Similarly, the payoff from a short position in a forward
contract, on one unit of an asset is given by

( F ST ) xN

Forward Contracts: Features

A Forward Contract has zero value at origination
Thus, no initial payment / receipt by either party at the
time of origination of the contract
The gain to one party in the contract is exactly equal to
the loss to the other party to the contract
Linear relationship between pay-off at maturity and the
spot price of the asset at maturity
Linear relationship between value of the forward contract
at any time after origination and the price of the
underlying asset

FX Forward
A FX forward is a bilateral (OTC) agreement to exchange
a pre-specified amount of one currency for another at a
pre-specified Forward Rate (Delivery price) at a predetermined date in the future
In trading parlance, also known as FX Outright

FX Forward: Contractual Terms

Contract terms specify

Deal date (date of origination of the contract)

Currency Pair (Base and Variable currency)
Notional Amount in one currency (usually the base currency)
Forward exchange rate (delivery price for base currency in terms of the
variable currency)
Base Currency Buyer
Base Currency Seller
Value date (date on which contract expires)
Settlement date (date on which the currencies are actually exchanged)
Locations for payment and delivery

FX
Forward/Outright

Rec: USD
Pay: INR

buy 3 m USD/ INR

Deal date

Spot date

Value date

Settlement date

FX Forward: Pay-offs at Maturity

The long or short position in an FX Forward corresponds to the base
currency
The Pay-offs are measured in variable currency
Long Position in FX Forward: Buy USD/INR 3
months Forward at Forward Exchange Rate
of 66.7225

Payoff to
buyer in Rs.

Short Position in FX Forward: Sell USD/INR 3

months Forward at Forward Exchange Rate of
66.7225

Payoff to
seller (in
Rs.)

66.7225

USD/INR
Spot at
Maturity

66.7225

USD/INR
Spot at
Maturity

Hedging Using FX Forwards

FX forwards help companies mitigate the risk inherent in
currency markets by predetermining the rate and date on
which they will purchase or sell a given amount of
foreign currency.
Using FX forwards, companies can:
Protect costs on products and services purchased abroad
Protect profit margins on products and services sold abroad
Lock-in exchange rates

Hedging Using FX Forwards

Transaction Risk: Impact of changes in exchange rates
on expected cashflows arising from future payments and
receipts in foreign currency
Indian Exporter: sells goods in Europe and will receive
Euro denominated payments in 3 months.
EUR/INR exchange rate falls, the rupee denominated revenues
of the exports will fall, all else being equal. Thus, the firms
profits will fall.
In order to hedge the risk of a rupee appreciation, the firm can
enter into a short position in an FX forward contract that allows it
sell the specified Euro amount at the end of 3 months at a
forward EUR/INR exchange rate lock in today

Hedging Using FX Forwards

Hedged Item
Exporter to Eurozone will
receive EUR 1 mio in 3 months

Underlying: Long position in

EUR 1 mio

Spot rate EUR/INR: 75.4,

Exporter believes Rupee will
appreciate against Euro in the
next 3 months (EUR/INR )

Hedging Instrument
Exporter sells EUR 1 mio
forward at forward EUR/INR
rate of 78. 5

Hedge: Short position in

EUR/INR forward

If EUR/INR is unfavourable in
3 months (i.e., < 78.5),
Exporter still receives Rs. 78.5
per Euro, that is Rs. 78.5 mio

Hedging Using FX Forwards

Unhedged Company
If at the end of 3 months, spot
rate EUR/INR is 75.00
Unhedged Company will
receive:
75.00 x 1,000,000 =
Rs. 75,000,000

Effect of Hedging
Hedged Company has already
sold EUR forward
Hedged Company will
receive:
78.5 x 1,000,000 = Rs.
78,500,000

Money saved by hedging: 78,500,000 75,000,000 =

Rs 3,500,000

Hedging Using FX Forwards

Payoff
Underlying Long
Position in EUR

Forward
EUR/INR
Rate

Hedged Position

0
Spot EUR/INR at
Maturity

Spot
EUR/INR at
Trade Date

Short Position in
EUR/INR Forward

Hedging Using FX Forwards

Indian Importer: imports its raw material from US and
must pay for them in Dollars.
If USD/INR exchange rate increases (that is, more rupees have
to be paid to purchase Dollars), the rupee denominated cost of
imports will rise, all else being equal. Thus, the firms profits will
fall.
How will the company hedge its exchange rate risk using FX
Forward Contract?

Hedging Using FX Forwards

Economic Risk: Impact of changes in exchange rates on
market value of assets and liabilities (even those that may
not directly involve currency exchange)
An Indian firm has the following balance sheet
Assets

(Rs. Million)

Liabilities

(Rs. Million)

Rupee Denominated

265.00

Outside Liabilities

300.00

Dollar Denominated 195.00

($3.00 million)

Owners Equity

160.00

Total Assets

Total Liabilities

460.00

460.00

Hedging Using FX Forwards

If the USD/INR exchange rate declines from 65.00 to 62.00, the rupee value of the dollar
denominated assets will fall to Rs. 186.00 million.
Since the value of the rupee denominated outside liabilities is unaffected by exchange rates,
and since owners equity is a residual claim, the economic value of equity will
correspondingly decline to Rs. 151.00 million.
How would the company hedge this exchange rate risk using FX Forward?

Leveraged Trades using FX

Forwards
News: The looming expiration of an emergency liquidity measure introduced during India's 2013
currency crisis comes at a risky time for the rupee, with about $20 billion in deposits expected to leave
the
country
as
global
investment
appetite
worsens.
Analysts warn the rupee - already Asia's worst performing currency against the U.S. dollar this year continues to look vulnerable ahead of September, when dollar term deposits that the country raised
from citizens abroad in 2013 start to mature.
How would you use FX forwards to make speculative profits from this trade?

As On 16-JUN-2016 15:39:31 Hours IST

ContractBest Bid
USDINR
280616
USDINR
270716
USDINR
290816
USDINR
280916
USDINR
261016
USDINR
281116
USDINR
281216
USDINR
270117

298

Best Ask
67.36 67.365

138 67.7025

Volume Value
No. of
(Contrac
Spread LTP
(in
OI
Trades
ts)
crores)
5,782.0 1,647,1
1286 0.005 67.3625 859077
33043
7
57

67.71

298 0.0075 67.705

12 68.0825 68.085

56 0.0025 68.085

49078 332.03 365,369

2971

13880

94.14 142,459

833

0.015 68.435

2430

16.62 71,858

95

18 68.765 68.7875

66 0.0225 68.745

717

4.93 20,582

40

72 69.105

69.13

50

0.025

69.11

459

3.17 15,770

29

40 69.4025

69.45

11 0.0475

69.43

760

5.28 12,434

25

0.1 69.7175

11

122 68.425

68.44

40 69.675 69.775

10

0.08

2,214

Non-Deliverable Forwards (NDF)

A non-deliverable forward foreign exchange contract
(NDF) is a FX forward contract in which one of the
currencies (usually that currency which has convertibility
restrictions) is not delivered.
Instead, a net payment is made by one party to the other
based on the contracted exchange rate and the spot
exchange rate on the day of settlement
A (notional) principal amount, forward exchange rate and
settlement date are locked in at the front end of the deal
On settlement date, there is no physical transfer of the
principal amounts involved in both currencies
A NDF contract is agreed on the basis of a net settlement
in dollars, euros, or other fully convertible currency.

Non-Deliverable Forwards (NDF)

The spot exchange rate on the basis of which an NDF is
settled at maturity is referred to as the Fixing Rate
The date on which the comparison between the NDF
exchange rate and the Fixing Rate is made to determine
the net-settlement amount is the Fixing Date
The date on which the net settlement amount is paid /
received is the Settlement Date
Absence of local forward markets, limited foreign access
to local currencies or restrictions on convertibility of local
currency have created the need for off-shore NDFs in
these currencies (Korean Won, Chinese Renminbi, New
Taiwan Dollar, Indonesian Rupiah, Philippine Peso,
Indian Rupee)

Hedging Using NDF

A FII has invested $1million in the Indian equity markets
for 3 months
Risks?
Equity market volatilities
USD/INR increase at the end of 3 months(weakening rupee)

Buys $ 1 million dollars 3 months forward at USD/INR

67.00)

Notional amount = $ 1 million

Contractual Forward USD/INR Exchange Rate: 67.00
Fixing Date: 3 months from deal date
Fixing Rate: RBI USD/INR Reference Rate on Fixing Date
Settlement Date: 2 business days after Fixing Date

NDF Pay-offs at Maturity

USD/INR Reference
Rate on Fixing Date

$ Equivalent Amount

Net Settlement

66.00

= Rs. 67.00 million /

66.00
=$ 1.015 million

=$ (1.015 1) million
= $ 0.015 million
FII pays NDF
counterparty

67.00

=Rs. 67.00 million /

67.00
=$ 1 million

0 net settlement

68.00

Rs. 67.00 million /

68.00
= $ 0.985 million

=$(1-0.985) million
=$ 0.015 million
FII receives from NDF
counterparty

Loss for the FII on the

FX Forward

Gain for the FII on the

FX Forward

FX Swaps
Definition
An FX swap is a contract to buy an amount of currency at an
agreed rate, and simultaneously resell the same amount of
currency for a later value date to the same counterpart, also
at an agreed rate (or vice versa).
Technically an FX swap is a combination of a spot deal and a
reverse outright deal.
Terminology
buy-and-sell; sell-and-buy
In FX swaps the term sell/buy refers to the forward leg.
So if the dealer buys a FX Swap, he sells spot and buys
forward (sell and buy) and if the dealer sells a FX Swap, he
buys spot and sells forward (buy and sell).

FX Swaps
A dealer wants to buy a one-year EUR/USD FX swap for
EUR 10 m.
Which transactions does he conclude?
Sell-and-Buy EUR 10 m
The dealer will buy Euro one-year Forward and
simultaneously sell Euro spot

FX Swaps
Amount:
In a regular FX swap the base currencies amount
both for the spot and the forward transaction is the
same, in the example EUR 10 m.
However FX swaps can be structured with uneven
amounts as well.
Interpretation:
A pair of offsetting FX transactions for different value
dates, concluded at the same time and on the same
deal ticket with the same counterpart
The dealer is actually lending EUR for 12-month time
and simultaneously, borrowing USD over the same
period without FX risk

FX Swaps Applications
FX swaps are often employed if an existing asset
(liability) in one currency shall be transformed into an
asset (liability) in another currency for a specified period.
Corporate treasuries use it for switching from one
currency to another
They are also used to efficiently roll over existing FX
hedging contracts to later maturities
FX swaps are off balance products with which a banks
cash liquidity position can be managed very efficiently.

FX Swap Applications
An Indian firm currently has INR 6,00,000 cash available
It also has a 3-month USD 10,000 funding requirement
and wishes to utilise its INR funds to meet this funding
requirement without incurring FX risk
It sells a 3 month USD/INR FX Swap, in which it buys
USD spot against INR and sells USD 3 months forward
against INR.

Forward Swap Applications

Comp and Extend: A forward FX transaction to compensate and

extend.
Say a hedge has been taken out for an expected currency payment or
receipt on a particular date. But the payment / receipt has been
subsequently postponed, requiring that the maturity of the underlying
hedge also be extended.
Example: An Indian company purchases some machinery priced in
USD in April. It expected to make a payment of USD 5 million to the
supplier when the goods are delivered in 3 mnths at the end of July. It
enters into a 3 mnth forward contract to buy USD against INR for
value 31 July at a rate of USD/INR = 60.08. In late June, the supplier
advises the company that delivery of the machinery will be delayed by
2 mnths to the end of September. As a result, the company decides to
roll over the hedge contract to 30 September. It enters into a FX swap
transaction to close out the original hedge and simultaneously
establish new cover for a maturity date of 30 September.
How does this transaction work?