forward contracts explained simply
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8/4/2019 Forward Contracts Explained Simply
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Use of Derivatives by Indian
Exporters
Presentation by FIMMDA to
CBI
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Foreign
BuyerIndian
Exporter
Order/LC
For T-Shirts
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
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ExporterBank
A
Request for Forward
Contract,
Value 1 year forward
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Bank
X
Bank
Y
Bank
A
Bank
Z
Borrow Sell
Rs 37.05
$ 0.95
Deposit/Lend
Rs 37.05
Receive Maturity
Proceeds
Rs 39.25
$ 0.95
1 2
3 4
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BankX
BankY
BankA
Bank
Z
Exporter
1$ Bill Rs 39.20 ( 39.25- 0.05)
Sell
$ 0.95
RS 37.05
Borrow
$ 0.95
Repay $ 1.00
Loan + Int
Lend/DepositRs 37.05
Receive maturity
Proceeds incldg IntRs 39.25
1 2
3
4
5
6
Spot Exchange rate 1 $ =
Rs 39.00
Forward Exchange Rate
1 $ = Rs 39.20
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3 Months later
Spot $/INR = Rs 35.00 (say)
After the Exporter booking a Forward Contract at 1$ = Rs 39.20 (value 1 year Fwd)
Foreign Buyer cancels the order placed with the Exporter
Bank
ARequest to cancel ForwardContract
Exporter
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Exporter
Bank
X
Bank
Z
Bank
YBank
A
Buy
$ 0.96
Rs33.60
Break
depositRs+ Int ( 37.59 )
Prepay $ loan +
Int =$ 0.96 =(Rs
0.50 )
Gain on Cancellation of Fwd Contract: Rs 37.59- Rs 33.60 = Rs 3.99
Less Interest on $ loan converted into Rs = Rs 0.50
Less Bank A’s operating Expenses + margin Rs 0.50
Amount payable to Exporter Rs 2.99
Rs 2.99 ( Gain to Exporter withoutmaking any Exports ! )
1
23
4
Spot Exch Rate
1 $ = Rs.35.00
Spot Exch
Rate :1$=Rs 35.00
1
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3 Months later
Spot $/INR = Rs 45.00 (say)
After the Exporter booking a Forward Contract at 1$ =
Rs 39.20 (value 1 year Fwd)Foreign Buyer cancels the order placed with the
Exporter
ExporterBank
ARequest to cancel ForwardContract
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Exporter
Bank
X
Bank
Z
Bank
YBank
A
Buy
$ 0.96
Rs 43.20
Break
depositRs+ Int ( 37.59 )
Prepay $ loan +
Int =$ 0.96 =(Rs 0.50 )
Loss on Cancellation of Fwd Contract: Rs 37.59- Rs 43.20 = Rs (5.61)
Add Interest on $ loan converted into Rs = Rs (0.50)
Add Bank A’s operating Expenses + margin Rs ( 0.50)
Amount Payable by the Exporter Rs (6.61)
Rs 6.61 ( Loss to Exporter)
1
23
4
Spot Exch Rate
1 $ = Rs.35.00
Spot Exch
Rate :1$=Rs 45.00
1
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IN SUMMARY
A Forward Contract booked by an Exporter seeks to protect his profitabilityfrom his business operations (Export of T-Shirts in the present examples)
As long as the Forward Contract is not cancelled, and the contracted export
takes place, 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 be a gain for 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, there could a loss to the Exporter ,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.
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MOVEMENTS OF USD/INR SPOT RATE DURING THE PERIOD UNDER
EXAMINATION
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Periods when an Exporter could have GAINED on account of Export Fwd
Contract Cancellations :
Period USD/INR Max Depreciation of USD/INR
_____ From - To Max Gains to Exporters (Gross)
5.3.07 – 26.07.07 44.68 40.87 3.81
17.8.07 – 10.10.07 41.34 39.24 2.10
17.3.08 - 17.4.08 40.74 39.79 0.95
6.86
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Periods when an Exporter could have LOST on account of Export Fwd
Contract Cancellations :
Period USD/INR Max Depreciation of
USD/INR
_____ From - To Max Loss to Exporters (Gross)
24.7.07- 17.8.07 40.24 - 41.34 1.10
16.01.08- 17.3.08 39.29 – 40.74 1.45
17.4.08 - 27.5.08 39.78 – 42.99 3.21
5.76
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OUR CONTENTION
When Forward Contracts were introduced in India, the Gains (if any ) on
account of cancellation of Forward Contracts were not passed on by banks toexporters
Losses (if any) on account of cancellation of Forward Contracts were passed
on to exporters
Earlier system prevented Exporters from speculative activity in the foreignexchange market.
With Liberalisation, Exporters allowed to get gains on Cancellation of
Forward Contracts, which set –off part of the losses on cancellations.
Emboldened by the profits made by booking and cancelling forward
contracts when the foreign currency was depreciating, (against genuine
underlying and genuine cancellation of orders), exporters started engaging in
speculative “Trading Activity”, totally un-connected with their core export
business.
Exporters made multiple –bookings under a single order, using the
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OUR CONTENTION (Contd )
The Exporters are not innocent and “gullible” but knowledgeable as
they have been in the exports and foreign exchange business much
longer than bank officers , (who are in an assignment for not more than
3 to 4 years)
While engaging in “Trading “ activities, even a seasoned Foreign
Exchange Dealer in a bank makes a loss. But banks have well –defined
Risk Management policies for cutting losses.
Exporters, while engaging in “Trading Activities” ( with/ without
underlying exports), did not have well –defined Risk Management
policies, resulting in losses , when the USD and other foreign currencies
started appreciating.
Having engaged in these trading activities, the exporters are now
blaming innocent bankers of defrauding them !!
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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 .
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Forward Contract USD/INR as on
delivery date
Fx P/L for
unhedged Exporter
Fx P/L for hedged
exporter1 4
1$ = Rs 39.00 1 $ = Rs 49.00 + Rs 10.00 Nil
1 $ = Rs 29.00 - (Rs 10.00) Nil
3. Loss on cancellation , if spot USD/INRhigher than Rs 39.00 on date of cancellation
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Advantages in booking Forward Contracts
1. No upfront fees
2. Fx risk due to currency fluctuation completely
eliminated
3. Profit on cancellation if spot USD/INR lower than Rs
39.00 on date of cancellation
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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 )
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OPTION PREMIUM
The buyer of the option pays an upfront fee (premium) to the seller of the
Option
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Forward contract Put optionLocks in forward rate (at 1$ =
Rs39.00 say )
Unable to enjoy upside ( 1 $ =
Rs 49.00 )
The exporter is under no
obligation to exercise option
and deliver underlying at
contracted rate.
Will exercise Option and
deliver underlying if rate issay 1 $ = Rs 35.00
Will not exercise Option if
rate is say 1 $ = Rs 49.00
Advantage of Put Options over forward contracts for and Exporter
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Disadvantages of Options as compared
to Forward ContractsForward Contract Put Option
No uprfront fees for booking contract >Upfront fees payable , depending on
volatility of USD/INR
Upside available only if exchange rate
exceeds fee/premium for buying the
Option.Example : Option Price 1 $ = Rs 39.00
Premium = Rs 2.00
Upside available only if
USD/INR exceeds - Rs 41.00
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Why did Exporters prefer Zero Cost
Option Structures ?
Exporters had been booking Forward
Contracts for ages, and there was no fee for
buying this hedging product.
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
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Enter – Zero cost Option Structures
Forward Contracts Zero –Cost Option Structure
>Down-side risk protected
>Upside potential limited to the rate at
which forward contract booked
> No Upfront Fees
>Down side protected with Exporter
buying a PUT Option
>Upside limited with Exporter
writing/selling a CALL Option
>Cost of Put Option set-off by premium
received by selling a CALL Option.
No net receipt or payment of premium,
hence no upfront fees
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Enter – Zero cost Option Structures
Forward Contracts Zero –Cost Option Structure
Cancellation , when spot is lower than
contracted rate, gives profit.
Cancellation of structure, when spot is
lower may not necessarily result in profit,
as Exporter would have to buy a
matching CALL, and the premium is a
function of ‘volatility’, and not a linearfunction.
In the case of Exotic Zero –Cost
structures , the Premium for buying back
the CALL, may be much more than the
favourable movement of the spot.
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Some arithmetic of Forwards and Zero
–Cost StructuresForward Contracts Zero-Cost Structures
Exporter books 3 $ forward at 1 $ = Rs
39.00
Exporter buys a Zero Cost Structure:
1 $ PUT @ 1 $ = Rs 39.00
2 $ CALL @ 1 $ = Rs 41.00
On Due Date : 1$ = Rs 49.00
Exporter delivers $ 3 at Rs 39.00
Fx P/L ( Rs 49.00 – 39.00 ) = Rs 10.00
On Due date : 1 $ = Rs 49.00
Buyer of CALL excercises option at Rs
41.00
Exporter delivers 2 $ CALL @ 1 $ = Rs
41.00
Exporter does not exercise PUT, and sells
underlying 1 $ @ 1 $ = Rs 49.00
Gain on PUT ( 49.00 – 39.00 ) = 10.00
Loss on CALL ( 49.00- 41.00) = 8.00
Total Loss ( 1 * 10) – ( 2*8) = ( 6)
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Some arithmetic of Forwards and Zero
–Cost StructuresForward Contracts Zero-Cost Structures
Exporter books 2 $ forward at 1 $ = Rs
39.00
Exporter buys a Zero Cost Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00
On Due Date : 1$ = Rs 49.00
Exporter delivers $ 2 at Rs 39.00
Fx P/L ( Rs 49.00 – 39.00 ) = (-)Rs 10.00
Total Fx Loss ( 2 * 10 ) = (-) Rs 20.00
On Due date : 1 $ = Rs 49.00
Buyer of CALL excercises option at Rs
41.00
Exporter delivers 2 $ CALL @ 1 $ = Rs
41.00
Exporter does not exercise PUT
Loss on CALL ( 49.00- 41.00) = 8.00
Total Loss ( 2*8) = (-) Rs 16
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Some arithmetic of Forwards and Zero
–Cost StructuresForward Contracts Zero-Cost Structures
Exporter books 2 $ forward at 1 $ = Rs
39.00
Exporter buys a Zero Cost Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00
On Due Date : 1 $ = Rs 29.00
Exporter delivers $ 2 at Rs 39.00Fx P/L ( Rs 39.00 – 29.00 ) = + Rs 10.00
Total Profit : ( 2 * 10.00) = + Rs 20.00
On Due date : 1 $ = Rs 29.00
Buyer of CALL does not excercise optionat Rs 41.00
Exporter sells 1 $ unhedged underlying @
1 $ = Rs 29.00
Exporter exercises PUT, and delivers
underlying 1 $ @ 1 $ = Rs 41.00
Gain on PUT (41.00-29.00) = Rs 12.00
Loss on unhedged underlying (39.00 –
29.00) = Rs 10.00 OR
(41.00- 29.00) = RS 12.00
Total Loss: (1 * 12) – ( 1 * 12) = (-) Rs 0.00
Or Profit : (1 * 12) – (1 * 10) = + Rs 2.00
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Conclusions regarding choice between
FC and Zero –Cost OptionForward 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, and contracts booked
at 39.00 were in loss.
Where there are no underlyings , FX Loss
adds to business loss, as corporate has tobuy the underlying in the market and
deliver.
From April 2007 to Oct 2008 –
USD/INR went up, and ZeroCost
Structures booked at 41.00 were in loss
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Some arithmetic of Forwards and Zero
–Cost StructuresForward Contracts Zero-Cost Structures
Exporter books 2 $ forward at 1 $ = Rs
39.00
Exporter buys a Zero Cost Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00
On Due Date : 1 $ = Rs 39.00
Exporter delivers $ 2 at Rs 39.00Fx P/L ( Rs 39.00 – 39.00 ) = NIL
Total Profit : NIL
On Due date : 1 $ = Rs 39.00
Buyer of CALL does not excercise optionat Rs 41.00
Exporter sells 1 $ unhedged underlying @
1 $ = Rs 39.00
Exporter exercises PUT, and delivers
underlying 1 $ @ 1 $ = Rs 41.00
Gain on PUT (41.00-39.00) = Rs 2.00
Loss on unhedged underlying (39.00 –
39.00) = NIL
Total Fx Profit : (2*1) = Rs2.00