Many clients we work with, especially SME clients, and more especially Exporters, tend to prefer an “Option Period” Forward Contract rather than a “Fixed Date” Forward Contract.
The “Option Period” Forward Contract is an exotic animal, most likely found only in the Indian forex market.
Why do Exporters like this strange hedging instrument so much? What “perceived” benefit does it give them? How does it work? And why is it actually a sub-optimal instrument?Many exporters do not enjoy the luxury of exporting on the basis of strict L/C terms. As such, many a times they do not know the exact date on which their receivable will materialise. At best they have a rough idea of the time period in which they can expect their customer to send the payment. Hence, when they want to undertake a Forward (Sale) Contract against their receivable, they are unable to give a specific value date for the forward contract to their bank. This is a common problemSo, banks have come up with what looks like an attractive, accommodative and customer-friendly solution, which is often more profitable for the bank than for the customer.
In a magnanimous gesture, the bank “allows” the exporter to deliver the dollars within a specified period (often a calendar month) instead of on a specific date.
For example, on April 23, an exporter who is expecting to receive payment by end of June is allowed to enter into a Forward Contract to sell dollars to the bank any day between June 1 and 30. For this, the exporter is entitled to get the Forward Premium for the period April 26 to May 31, or for little more than one month. Note here that the forward period will be counted from April 26 onward since April 25 is the Spot date for April 23.
The bank, on the other hand, can go out into the market and sells Dollars forward for value date June 30, instead of value date May 31! In other words, it sells two months five days forward gets premium for 66 days (April 26 to June 30) instead of for 36 days (April 26 to May 31).
What happens in case the payment comes in earlier than Jun 30, say on June 15? Under the Option Period Forward Contract, the exporter simply delivers the dollars to the bank and is credited with the Forward Rate, as previously agreed, that was then applicable on April 23, for May 31. He is unaware of the fact that he has foregone premium for 15 days.What does the bank do, on the other hand? The bank, which had previously “received” premium for the entire period from April 26 to June 30 from the market, “pays” premium for the period June 16 to June 30, back to the market. On a net basis, therefore, the exporter receives premium for 36 days months whereas the bank receives premium for 51 days.
This is pure profit for the bank, which could as well have been to the account of the Exporter if he had done the same thing as the bank, viz. (1) Sold Forward for fixed date 30-June (2) Given Early Delivery on 15-June and (3) Paid back premium for the period 16-June to 30-June through a swap transaction.
An Early Delivery is a perfectly correct and legitimate transaction, well within the RBI's guidelines, and has been around for at least two decades, quite possibly longer.
Many Exporters do not avail this facility because they are either not aware of this facility or they do not want to take on any additional administrative work.
The Option Forward Contract is bad for the Importer as well. Say on April 23, an Importer asks for an option forward contract for June 1-30, he is asked to pay premium for the full 66 days from April 26 to June 30. Instead, he could have asked for a fixed date forward contract for value date June 30. Then, if has to “take” early delivery of the dollars from the bank on 15-June, he can ask to be refunded the then prevailing forward premium for 15 days, from June 16 to June 30. In this manner he ends up paying premium for only 51 days, instead of for 66 days.
Both exporters and importers need to wake up and look at the amount of money they are losing by taking option period forward contracts and not hedging for a fixed date.
The average monthly premium over the last couple of years has been 20-30 paise. We can safely assume that roughly half of this is foregone when an Exporter asks a bank for an option period forward contract instead of giving “early delivery” on a fixed date forward contract.
Ten paise foregone on every $1 million sold every month translates into foregone revenues of Rs 12 lakh every year. Is that worth losing? Or is it worth capturing? You decide.
(The author is Chief Currency Strategist at kshitij.com. The views are personal. He can be reached at firstname.lastname@example.org)