The Hindu Business Line : How forward contracts help

Consider the following illustration: An exporter executes an order worth $1 million on May 1, 2008, and is to receive the proceeds on August 1, 2008. An importer gets goods worth $1 million on May 1and has to pay the amount on August 1. Both of them have factored Rs 40 to a dollar for their profit/margin calculations.

If the dollar-rupee rate moves from 40 to 38 as on August 1, the exporter receives only Rs 3.8 crore and loses Rs 20 lakh. The importer needs to pay only Rs 3.8 crore and stands to gain Rs 20 lakh.

Additional charges

If the rate were to move up to Rs 42/$ by August 1, it would be a reverse. The exporter gains and the importer loses, Rs 20 lakh respectively. If both of them book forward contracts with their bankers on May 1for delivery on August 1, at a rate of Rs 40/$, in both the scenarios, the rate changing to 38 or 40 a dollar, they would be receiving and paying only Rs 4 crore, respectively. The difference, if any, in the market rates would be a notional gain or loss and doesn’t affect the margins.

Once a forward contract is booked, the rate and the period get fixed. The cost or gain would normally be equal to the interest rate difference between the dollar and the rupee. Any changes in dates of delivery would of course entail additional charges, commensurate with changes in currency rates.

If the forward contract is to be cancelled, the cost or gain would be the difference amount of Rs 20 lakh. To be paid to the bank, depending on which way the currency moves.

At the time of booking the contract, because of the difference in interest rates for the two currencies, the US dollar carries a premium of about 0.25 to 0.50 per cent of the rate as forward premium for the three-month period. It would be a gain/income for the exporters and (as he sells the forward dollar) cost for the importer as he buys the forward dollar at a premium. These charges can sometimes be distorted in volatile markets and based on demand and supply position in the Indian market.

Normally forward contracts can be booked for deliveries up to 18 months based on projected cash flows either for a lump-sum amount or part amounts for various delivery periods. It is possible to book the contracts for even five years, but as it is difficult to predict market behaviour for longer periods, the markets are comfortable operating on half-yearly rollover basis, a fee being collected for each rollover.

The example can be extrapolated for any pair of currencies.

Options offer better choices

Considering the same example, an option works as follows:

The exporter can buy an option to sell $1 million @ Rs 40 on August 1.

The importer can buy an option to sell $1 million @ Rs 40 on August 1.

An option confers a right to buy/sell the currency at the agreed level of Rs 40/$ on August 1, but one can choose to ignore it should the rate move in one’s favour.

In the example, if the rate moves to Rs 38 on August 1, the exporter can happily exercise the option to sell and receive Rs 4 crore (with a notional gain of Rs 20 lakh). The importer can ignore the option, buy $1 million from the open market at Rs 3.8 crore (gain of Rs 20 lakh).

If the rate goes up to Rs 42/$, the exporter can ignore the option and sell the dollars in the market for Rs 4.2 crore (a gain of Rs 20 lakh). The importer can exercise the option to buy $1 million at Rs 4 crore (a notional saving of Rs 20 lakh).

Thus either way it is a win-win situation for both the exporter and the importer. The only loss or cost would be the premium paid upfront to the writer of the option, which will be a small percentage of the amount involved, calculated on the basis of anticipated rate movements, the strike price, and the period of maturity. Banks which normally write the options, cover themselves in the inter-bank market.

Currency swaps are complex

Currency swaps involve swapping of receivables and payables into a currency other than the contracted (invoice) currency. They can be for a one-time amount or a stream of inflows or outflows. The objectives can be two-fold. One, to gain from possible currency rate movements that were not contemplated at the time of original contract for exports or imports and the other to meet the cash flow mismatches in multiple currencies. The possibilities are immense.

Consider the case of the exporter and importer in the cited example. Anticipating the Japanese yen to depreciate against the US dollar, while the yen-rupee rate remaining stable, an exporter can enter into a $-yen swap with his bank.

If on May 1the $ = 100 yen and 1 yen = 0.40 rupee, $1 million will work out to yen 100 million = Rs 40 lakh.

A view is taken that on August 1 the dollar will rise against the yen to $=110 yen and the yen-rupee rate will hover around the same level of 1 yen = 0.40 rupee.

On August 1, $1 million = 110 million yen, yielding Rs 4.4 crore (a gain of Rs 40 lakh)

If, however, the yen appreciates against the dollar to, say, $=95 yen as on August 1, $1 million will become yen 95 million, in turn yielding only Rs 3.8 crore (a loss of Rs 20 lakh)

Normally in spot markets, if $-yen rate changes the yen-rupee rate also moves in tandem evening out any hedging opportunities and offering no advantage. But forward markets movements may be different because of expectations or changes in the relative economies, trade flows between the home countries and the demand and supply position at the time.

If the importer holds a view that the dollar will go down to yen 95 as on August 1, while the yen-rupee rate holds, he can enter into a currency swap opting to pay for the imports in yen instead of the US dollar. If the expectation comes true, he has to pay only yen 95 million or Rs 3.8 crore (a gain of Rs 20 lakh). Contrary to expectations, if the yen moves down to yen 110/$, he has to shell out Rs 4.4 crore (a loss of Rs 40 lakh).

Though only simple illustrations are given, it is quite possible that simultaneously both the $-yen and yen-rupee move in either direction and taking a view is a complex exercise as several currencies are involved.

Instead of the yen, the swap currency could be the euro, Swiss franc or the Sterling pound. In case of a stream of cash flows over a period, the exercise can be interesting and more complex. Only regular players in the forex markets can attempt to formulate a view.

(The author is a former Managing Director of State Bank of Mysore.)

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How forward contracts help