FORWARD CONTRACTS

Indian
Exporter

Foreign
Buyer
Order/LC For TShirts
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 ……. $ 1 = Rs 39.00
Therefore USD Price per T-Shirt : $ 10

Value 1 year forward Bank A .Exporter Request for Forward Contract.

95 Rs 37.05 Rs 39.25 Bank Z Bank Y .05 4 Receive Maturity Proceeds 3 Deposit/Le nd Rs 37.95 Bank A Sel l $ 0.1 2 Borrow Bank X $ 0.

00 Loan + Int 3 Lend/Deposi t Rs 37.20 1$ Bill 1 Borrow $ 0.25.Forward Exchange Rate 1 $ = Rs 39.0.20 ( 39.25 Spot Exchange rate 1 $ = Rs 39.05 Exporter 5 Rs 39.00 .95 Bank A RS 37.95 Bank X 6 Repay $ 1.05) 2 Sell $ 0.05 Bank Y 4 Bank Z Receive maturity Proceeds incldg Int Rs 39.

00 (say) After the Exporter booking a Forward Contract at 1$ = Rs 39.3 Months later Spot $/INR = Rs 35.20 (value 1 year Fwd) Foreign Buyer cancels the order placed with the Exporter Exporter Request to cancel Forward Contract Bank A .

35.60 = Rs 3.00 Gain on Cancellation of Fwd Contract: Rs 37.60 Spot Exch Rate Bank Spot: Z Exch Rate 1$=Rs 35.99 Less Interest on $ loan converted into Rs = Rs 0.00 1$= 1 Rs.99 .59Rs 33.50 ) Break deposit Rs 2.50 Amount payable to Exporter Rs 2.Exporter 4 Bank X 3 Prepay $ loan + Int = $ 0.99 ( Gain to Exporter without making any Exports ! ) Buy 2 Bank $ 0.96 Bank Y A 1 Rs+ Int ( 37.59 ) Rs 33.96 =(Rs 0.50 Less Bank A’s operating Expenses + margin Rs 0.

00 (say) After the Exporter booking a Forward Contract at 1$ = Rs 39.3 Months later Spot $/INR = Rs 45.20 (value 1 year Fwd) Foreign Buyer cancels the order placed with the Exporter Exporter Request to cancel Forward Contract Bank A .

59 ) 2 Buy $ 0.96 Bank Y Rs 43.59Rs 43.20 Spot Exch Rate Bank Spot: Z Exch Rate 1$=Rs 45.50) .96 =(Rs 0.Exporter 4 Bank X 3 Prepay $ loan + Int = $ 0.50) Add Bank A’s operating Expenses + margin Rs ( 0.00 1$= 1 Rs.20 = Rs (5.00 Loss on Cancellation of Fwd Contract: Rs 37.61) Add Interest on $ loan converted into Rs = Rs (0.61 ( Loss to Exporter) Bank A 1 Rs+ Int ( 37.35.50 ) Break deposit Rs 6.

.IN SUMMARY A Forward Contract booked by an Exporter seeks to protect his profitability from his business operations (Export of T-Shirts in the present examples) As long as the Forward Contract is not cancelled. there could be a gain for the Exporter . the Exporter does not make any gains/losses on account of the fluctuations in the foreign currency versus INR (if exports invoiced in foreign currency  If a Forward Contract(Exports) is cancelled. there could a loss to the Exporter . if the foreign currency (vs INR) price depreciates as on date of cancellation as compared to the spot rate on date of booking the contract. If a Forward Contract(Exports) is cancelled. and the contracted export takes place. if the foreign currency (vs INR) price appreciates as on date of cancellation as compared to the spot rate on date of booking the contract.

MOVEMENTS OF USD/INR SPOT RATE DURING THE PERIOD UNDER EXAMINATION .

07 – 26.07 – 10.81 17.Periods when an Exporter could have GAINED on account of Export Fwd Contract Cancellations : Period USD/INR Depreciation of USD/INR _____ From To Exporters (Gross) Max Max Gains to 5.34 39.08 .4.10 17.07 41.79 0.95 6.07 44.68 40.17.86 .3.07.24 2.8.3.10.08 40.87 3.74 39.

08 17.76 .01.3.41.Periods when an Exporter could have LOST on account of Export Fwd Contract Cancellations : Period USD/INR Depreciation of USD/INR _____ From To Exporters (Gross) 24.08 .17.5.7.24 .21 5.08 39.99 Max Max Loss to 1.8.34 16.17.29 – 40.27.4.45 3.08.10 1.07.78 – 42.07 40.74 39.

.Disadvantages of Forward Contracts • Locks an Exporter into a fixed rate of exchange ( 1 $ = Rs 39.00 say ) • • Exporter has to deliver the underlying whatever may be the Exchange Rate on date of delivery .

00 .Forward Contract USD/INR as on Fx P/L for delivery date unhedged Exporter 1$ = Rs 39. if spot USD/INRhigher than Rs 39.(Rs 10. Loss on cancellation .00 1 $ = Rs 49.00 on date of cancellation .00 1 $ = Rs 29.00) Fx P/L for hedged exporter1 4 Nil Nil 3.00 + Rs 10.

Advantages in booking Forward Contracts 1.00 on date of cancellation . Fx risk due to currency fluctuation completely eliminated 3. Profit on cancellation if spot USD/INR lower than Rs 39. No upfront fees 2.

Options A better hedging tool • PUT OPTION : Gives the buyer (exporter) the RIGHT but not the OBLIGATION to deliver (SELL) the underlying (USD/INR) on a specified future date at a specified exchange rate fixed now (1 $ = Rs39.00 say ) . • CALL OPTION : Gives the buyer (importer) the RIGHT but not the OBLIGATION to take delivery (BUY) underlying (USD/INR) at a specified exchange rate fixed now (1 $ = Rs 39.00 say ) .

OPTION PREMIUM The buyer of the option pays an upfront fee (premium) to the seller of the Option .

00 .00 Will not exercise Option if rate is say 1 $ = Rs 49.  Will exercise Option and deliver underlying if rate is say 1 $ = Rs 35.00 say ) Unable to enjoy upside ( 1 $ = Rs 49.Advantage of Put Options over forward contracts for and Exporter Forward contract Put option Locks in forward rate (at 1$ = Rs39.00 ) The exporter is under no obligation to exercise option and deliver underlying at contracted rate.

00 Premium = Rs 2.Disadvantages of Options as compared to Forward Contracts Forward Contract Put Option No uprfront fees for booking contract >Upfront fees payable .Rs 41. depending on volatility of USD/INR Upside available only if exchange rate exceeds fee/premium for buying the Option.00 Upside available only if USD/INR exceeds .00 . Example : Option Price 1 $ = Rs 39.

and there was no fee for buying this hedging product.Why did Exporters prefer Zero Cost Option Structures ?  Exporters had been booking Forward Contracts for ages.  They did not want to pay the Option premium which would cut into their business profits. as cost of Option could not be loaded on to the foreign buyer .

hence no upfront fees . No net receipt or payment of premium.Enter – Zero cost Option Structures Forward Contracts Zero –Cost Option Structure >Down-side risk protected >Down side protected with Exporter buying a PUT Option >Upside potential limited to the rate at which forward contract booked > No Upfront Fees >Upside limited with Exporter writing/selling a CALL Option >Cost of Put Option set-off by premium received by selling a CALL Option.

and the premium is a function of ‘volatility’. when spot is lower than contracted rate. gives profit. as Exporter would have to buy a matching CALL. .  Cancellation of structure. In the case of Exotic Zero –Cost structures . and not a linear function.Enter – Zero cost Option Structures Forward Contracts Zero –Cost Option Structure Cancellation . when spot is lower may not necessarily result in profit. the Premium for buying back the CALL. may be much more than the favourable movement of the spot.

00 ) = 10.00 Exporter does not exercise PUT.00 .Some arithmetic of Forwards and Zero – Cost Structures Forward Contracts Zero-Cost Structures Exporter books 3 $ forward at 1 $ = Rs 39. and sells underlying 1 $ @ 1 $ = Rs 49.00 Buyer of CALL excercises option at Rs 41.00 On Due date : 1 $ = Rs 49.00 Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 39.00 Fx P/L ( Rs 49.00 Exporter delivers 2 $ CALL @ 1 $ = Rs 41.00 Gain on PUT ( 49.00 ) = Rs 10.00 – 39.00 Exporter delivers $ 3 at Rs 39.00 On Due Date : 1$ = Rs 49.00 – 39.00 2 $ CALL @ 1 $ = Rs 41.

00 – 39.00 Exporter delivers $ 2 at Rs 39.00 Buyer of CALL excercises option at Rs 41.00 Exporter does not exercise PUT Loss on CALL ( 49.00 On Due Date : 1$ = Rs 49.Some arithmetic of Forwards and Zero – Cost Structures Forward Contracts Zero-Cost Structures Exporter books 2 $ forward at 1 $ = Rs 39.00 Fx P/L ( Rs 49.00 ) = (-)Rs 10.41.00 Total Fx Loss ( 2 * 10 ) = (-) Rs 20.00 Exporter delivers 2 $ CALL @ 1 $ = Rs 41.00 Total Loss ( 2*8) = (-) Rs 16 .00 2 $ CALL @ 1 $ = Rs 41.00) = 8.00.00 Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.00 On Due date : 1 $ = Rs 49.

00 On Due date : 1 $ = Rs 29.00 Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.00 .Some arithmetic of Forwards and Zero – Cost Structures Forward Contracts Zero-Cost Structures Exporter books 2 $ forward at 1 $ = Rs 39.00 ) = + Rs 10.00) = Rs 12.00) = + Rs 20.00 2 $ CALL @ 1 $ = Rs 41. and delivers underlying 1 $ @ 1 $ = Rs 41.00 – 29.00 Total Profit : ( 2 * 10.00 Fx P/L ( Rs 39.00 Buyer of CALL does not excercise option at Rs 41.00 On Due Date : 1 $ = Rs 29.00 Exporter delivers $ 2 at Rs 39.00 Gain on PUT (41.00 Exporter exercises PUT.00 Exporter sells 1 $ unhedged underlying @ 1 $ = Rs 29.00-29.

as corporate has to buy the underlying in the market and . From April 2007 to Oct 2008 – USD/INR went up. and ZeroCost Structures booked at 41.00 were in loss Where there are no underlyings . FX Loss adds to business loss.Conclusions regarding choice between FC and Zero –Cost Option Forward Contract Zero Cost Option Structure Most advantageous when : Spot Lower than Contracted Rate Most Advantageous when : Spot Equal to the Forward Contract Rate Least Advantageous When : Spot Higher than Contracted Rate Least Advantageous when : Spot higher than Strike/Contracted Rate From April 2007 to Oct 2008 – USD/INR went up.00 were in loss. and contracts booked at 39.

00 On Due Date : 1 $ = Rs 39.00 Fx P/L ( Rs 39.00 Exporter exercises PUT.00 . and delivers underlying 1 $ @ 1 $ = Rs 41.00) = Rs 2.00 Buyer of CALL does not excercise option at Rs 41.00 Exporter delivers $ 2 at Rs 39.00 2 $ CALL @ 1 $ = Rs 41.00-39.00 ) = NIL Total Profit : NIL On Due date : 1 $ = Rs 39.Some arithmetic of Forwards and Zero – Cost Structures Forward Contracts Zero-Cost Structures Exporter books 2 $ forward at 1 $ = Rs 39.00 Gain on PUT (41.00 – 39.00 Exporter sells 1 $ unhedged underlying @ 1 $ = Rs 39.00 Exporter buys a Zero Cost Structure: 1 $ PUT @ 1 $ = Rs 41.