Currency forwards

1
Currency forwards
2
Background

• Foreign exchange rates fluctuate constantly
• Fluctuations expose parties dealing in foreign
  exchange to risk
• Risk is the possibility of incurring loss
• Examples
• Exporter expecting to receive foreign currency in
  the future
• Importer obliged to make payment in a foreign
  currency
• Parties would like to hedge the risk

3
Financial derivatives

• Instruments for hedging risk
• Has an underlying asset foreign currency, share

4
Types of derivatives

• Forwards
• Futures
• Options
• Swaps

5
Currency forwards meaning

• Forward contracts are part of everyday life
• Examples luxury car, real estate
• Definition
• An agreement
• To buy or sell
• An asset ( commodity or financial asset)
• At a predetermined price
• Within a specified future date
• Contract for forward delivery, not ready (spot)
  delivery
• The buyer has a long position the seller has a
  short position

6
Forward dealings in foreign currency exporter

• An exporter exports goods worth USD 1,00,000 to
  USA
• Receipt of USD expected after 3 months
• Current exchange rate 1 USD Rs.46
• Decline in the value of USD is anticipated
• Exporter enters into a forward contract to sell
  USD after 3 months at Rs.45.70 /USD
• After 3 months
• If USD 1 Rs.45 gain of Rs.70,000
• If USD 1 Rs.45.70 no profit, no loss
• If USD 1 Rs.46.50 opportunity loss (loses
  opportunity to gain Rs.80,000)

7
Forward dealings in foreign currency importer

• An importer has imported goods worth Euro
  1,00,000 from Europe
• Payment to be made after 3 months
• Current exchange rate 1 Euro Rs.58
• Increase in the value of Euro is anticipated
• Importer enters into a forward contract to buy
  Euro after 3 months at Rs.58.40 /Euro
• After 3 months
• If Euro 1 Rs.60 gain of Rs.1,60,000
• If Euro 1 Rs.58.40 no profit, no loss
• If Euro 1 Rs.57.40 - opportunity loss (loses
  opportunity to gain Rs.1,00,000)

8
Currency forwards merits and demerits

• Merit
• Helps in hedging risk
• Demerits
• Does not provide opportunity for making profit
• There is illiquidity (forwards have to be
  executed being bilateral private contracts)
• There is default risk (credit risk) (the party at
  disadvantage may default)

9
Operation of financial derivates

• Facilitates exchange of financial assets in the
  future at prices determined in the present
• Enables participants to lock in a price for the
  future transaction
• Uncertainty arising out of future fluctuations in
  asset prices is eliminated
• Example an exporter can convert foreign currency
  into Indian rupees in future at a predetermined
  price