Currency Forwards

Foreign Exchange Transactions

The foreign exchange transactions can be broadly classified into following categories depending upon the time of settlement :

1)

Spot Transactions:
If the transactions are to be settled immediately then they are termed as spot transactions and the rates applicable for such transactions are known as spot rates.

The spot transactions are to be settled within two business days of the transaction. The
settlement date is known as value date.

2)

Forward Transactions :
Transactions where the rate is fixed now but the delivery of currencies is delayed are

known as forward contracts.

For Example, 1 month forward contract for buying of dollar by an Indian firm at Rs.45.00/dollar implies that physical exchange of dollar and rupees would take place 1 month after the date of transactions, but the rate is decided at the time of entering into the

contract. It does not matter what the exchange rate prevails on the day of settlement.

Spot & Forward Rates

Currency
US Dollar Euro Pound Sterling Swiss Franc Danish Kroner Australian Dollar Canadian Dollar

Spot
43.97 53.87 79.61 34.72 7.22 33.81 37.14

1 month
44.02 54.01 79.65 34.85 7.24 33.83 37.21

3 months
44.06 54.22 76.56 35.07 7.27 33.74 37.31

6 months
44.13 54.57 79.71 35.41 7.32 33.68 37.46

Source: Business Line, 17 September, 2005

Swap Transaction

A swap transaction is a combination of spot and forward transactions. The spot & forward legs of the swaps are opposite and equal in value.

For example, A Bank buys $10,000 spot from another Bank and simultaneously enter into 1
month forward contract to sell $10,000 to the same bank.

The rates for buying spot and selling forward would be different but are known today itself. With both buying and selling rates known, the Bank is not exposed to any risk of changing exchange rates.

The buying of foreign currency today and selling later, or selling today and buying later is a composite contract in the swap deal.

However, the same position is obtainable with two independent but opposite and equal contracts one spot and another forward. An independent forward contract is called outright forward contract. Two independent contracts one spot and another outright forward are more expensive than the composite swap contract.

Swap Transaction for Bank A

Sells $ forward

Customer/ Exporter

Buys $ forward

Bank A

Swap deal Buys $ Spot

Bank B

Sells $ Spot

Option Forwards
Option forward is not a fixed date contract. It provides flexibility to deliver foreign exchange during a period, called option period.
When the exact timing of the cash inflow/outflow is uncertain the forward contracts can be booked for delivery within a given period, called option period rather than on a specific date. For example, an exporter expecting payment anytime between 2 to 3 months would like to have the flexibility where he can deliver the foreign exchange anytime between 2 and 3 months of booking forward contract. Example:

Time of Contract

Earliest Delivery Option Period

Latest Delivery

Examples
Companies Arvind Mills Instruments Forward Contracts Option Contract Tata Consultancy Services Forward Contracts Option Contracts Currency (million) 152.98 ($-INR) 2.25 (GBP-INR) 5 (INR-$) 122.5 ($-INR) 15 (Euro-INR) 21 (GBP-INR) 830 ($-INR) 47.5 (Euro-INR) 76.5 (GBP-INR) Rs. (crore) 703.67 21.88 547.16 265.75 4057 Nature of Exposure Most of the revenue is either in $ or linked to $ due to export.

Revenues largely denominated in foreign currency, predominantly US$, GBP, and Euro. Other currencies include Australian $, Canadian $, South African Rand, and Swiss Franc

$-INR Forward contracts denote selling of USD forwards to convert revenues to INR. INR-$ Forward contracts denote buying of USD forwards to meet USD payment obligations. $-INR Option contracts are Put options to sell USD. INR-$ are Call options to buy USD.

Difference between Forwards & Futures

Sr.No. Point of Difference
1 Size of contracts

Forwards
Decided between buyer and seller

Futures
Standardized by exchange for each underlying (lot size)

2
3 4 5 6

Price of contract
Marking-to-margin Margin Counter-party risk Liquidity

Remains fixed till maturity

Not done No margin required Present No liquidity

Changes everyday on the exchange

Marked-to-market everyday Margins have to be paid by both parties Not present Highly liquid

7
8

Nature of market
Mode of delivery

Over the counter

Specifically decided. Some of the contracts result in delivery.

Traded on the exchange

Standardized. Most of the contracts do not result in delivery.