Forward Contracts

© 2011 Dorling Kindersley (India) Pvt. Ltd. Objectives What are forward contracts? How are forward contracts used? How are commodity forward contracts priced? What are currency forward contracts? What are the uses of currency forward contracts? How are currency forward contracts priced? What is a forward rate agreement? What are the uses of forward rate agreements? © 2011 Dorling Kindersley (India) Pvt. Ltd.

What is a Forward Contract? An agreement to buy or sell a specified asset at a certain time in the future, for a specified price agreed upon at the time of entering into the contract Actual exchange of cash and assets takes place at a future time Price at which exchange will take place is determined at the current time © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. Why Forward Contracts? Used to reduce price risk, so that a known price can be locked in for a future transaction Example: A farmer who grows rice and a merchant who sells it can fix the price of rice at harvest time through a forward contract, even at the time the rice is planted © 2011 Dorling Kindersley (India) Pvt. Ltd.

Risks in Forward Contracts When entered into, price at which future transaction will take place is fixed On the day exchange of goods and cash will occur, market price could be different from forward price: this would cause one party to gain and the other to lose Forward contracts are zero-sum-games, i.e. gain for one party is equal to loss for other party © 2011 Dorling Kindersley (India) Pvt. Ltd.

Motives for Forward Contract If forward contracts can result in losses, why do traders enter into them? To lock in the price for a future transaction, so that future price uncertainty is reduced Future cash flows can be forecast more accurately © 2011 Dorling Kindersley (India) Pvt. Ltd.

Advantages of Forward Contracts A flexible tool which reduces price uncertainty The amount, quality and delivery details of an asset can be negotiated between both parties according to their needs Tailored such that price uncertainty for both parties can be eliminated © 2011 Dorling Kindersley (India) Pvt. Ltd.

Problems with Forward Contracts Finding parties with matching needs Non-performance of contracts or counter-party risk Non-transferability of contracts © 2011 Dorling Kindersley (India) Pvt. Ltd.

Pricing of Commodity Forward Contracts Commodity forward contracts are priced as: f0 = P0 + C Where: f0 = forward price of the commodity determined for future exchange at the current time P0 = current market price or spot price of the commodity C = cost of storage or cost of carry © 2011 Dorling Kindersley (India) Pvt. Ltd.

Pricing of Commodity Forward Contracts Cost of storage can include: Actual cost of storage in the warehouse, including rent Opportunity cost of funds invested in buying goods Expenses in connection with storage, i.e. freight & insurance © 2011 Dorling Kindersley (India) Pvt. Ltd.

Example of Pricing of Commodity Forwards Assume that the price of rice is INR 25/kg on July 1. A farmer expects his harvest to be 20 tonnes (20,000kg) in December, and plans to sell this amount on January 1 of next year using a forward contract. If the cost of carry is 10% of the current market price, what will be the forward price? What would be the exchange on January 1? Forward price = Spot price + Cost of carry F0 = INR 25 + 25*10% = INR 27.50 per kg On January 1, the farmer would deliver 20,000 kg of rice, and will receive INR 550,000. © 2011 Dorling Kindersley (India) Pvt. Ltd.

Currency Forward Contracts Contracts for buying or selling a foreign currency on a future date at an exchange rate determined at the current time Used by importers and exporters who have known future foreign currency cash flows Used to eliminate exchange rate risk © 2011 Dorling Kindersley (India) Pvt. Ltd.

Examples of Currency Forward Contracts Revenue for Infosys in USD to be converted into INR periodically Ford India pays periodically for parts imported from the USA An importer of goods from Europe needs to pay Euro after 90 days, and can enter into a 90-day forward contract to buy Euro in order to reduce exchange rate risk An exporter of goods to Australia will receive AUD after 30 days and can enter into a 30-day forward contract to sell AUD © 2011 Dorling Kindersley (India) Pvt. Ltd.

Operation of Currency Forward Market In India, forward contracts are offered by banks A hedger will approach a bank authorized by RBI and the bank will provide the quotes for the forward rate On settlement day, hedger and bank will exchange currencies at the agreed-upon forward rate © 2011 Dorling Kindersley (India) Pvt. Ltd.

Risks in Using Currency Forwards Since a currency forward is a contract between a hedger and a bank, the two parties will face different risks Hedger will face the risk of gain or loss if the actual market exchange rate is different from the forward rate Banks face higher risk as a forward contract exposes bank to an open position in foreign currency Banks should hedge risk by Entering into an opposite forward contract Entering into either a future or an options contract © 2011 Dorling Kindersley (India) Pvt. Ltd.

Uses of Currency Forwards Importers who are to pay foreign currency at a future time Exporters who will receive foreign currency at a future time Investors in foreign currency denominated stocks & bonds Borrowers of foreign currency denominated loans © 2011 Dorling Kindersley (India) Pvt. Ltd.

Characteristics of Currency Forwards Party entering into currency forward has an exposure of that currency Amount of exposure known with certainty Time at which exposure develops is known with certainty RBI regulations require banks to verify these details Regulations provide for cancellation and renegotiation of contracts © 2011 Dorling Kindersley (India) Pvt. Ltd.

Pricing of Currency Forward Contracts Based on principle of covered interest rate arbitrage Currency with higher interest rate should depreciate by approximately by the interest rate differential Interest rate should reflect the rate for the forward contract period © 2011 Dorling Kindersley (India) Pvt. Ltd.

Example of Forward Rate Calculation Let rUSD = 6% and rINR = 8%. Current spot rate (s0) is USD 1 = INR 45.32 3-month forward rate is calculated as: © 2011 Dorling Kindersley (India) Pvt. Ltd.

Covered Interest Arbitrage According to forward contract pricing, forward premium ≈ interest rate differential If this relationship is violated, there will be arbitrage opportunity and known as covered interest arbitrage Arbitrage is undertaken so that currency which is overvalued with respect to forward rate will be sold at the current time © 2011 Dorling Kindersley (India) Pvt. Ltd.

Example of Covered Interest Arbitrage rINR = 8%, rUSD = 6%, s0 = INR 45.32, 3-month forward rate = INR 46.00 According to pricing relationship, f0 = INR 45.32 Since actual forward rate > theoretical rate, INR is relatively undervalued and USD is relatively overvalued with respect to forward rate Should sell USD forward, so borrow INR currently and invest in USD If INR 45.32 is borrowed, arbitrage profit = INR 0.4636 million © 2011 Dorling Kindersley (India) Pvt. Ltd.

Rolling Over Currency Forward Rates According to regulations, currency forward contracts can be rolled over if exposure changes Some traders also use rollover of contracts to avoid losses when fulfilling forward contracts can lead to losses, because of changes in market rates Care must be taken while rolling over contracts © 2011 Dorling Kindersley (India) Pvt. Ltd.

Interest Rate Forward Contracts Also called Forward Rate Agreements (FRA) Used by companies planning to borrow at a future time, or by those who have floating-rate loans Used by banks to hedge interest rate risk while lending money © 2011 Dorling Kindersley (India) Pvt. Ltd.

Mechanics of a Forward Rate Agreement Under the agreement, the two parties (borrower and counter- party) to the contract agree upon a future interest rate at a set time Borrower will borrow at the market interest rate, called the reference rate, as identified in the agreement If actual rate of borrowing is greater than the agreed rate, counterparty will pay cash to the borrower If actual rate of borrowing is less than agreed rate, borrower will pay cash to counterparty Cash settlement will take place at the time borrowing takes place © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. FRA Time Periods Time at which FRA is entered into FRA settlement date End-of-Exposure date 30 x 2010 FRA  Settled on day 30, end-of-exposure on day 2010, indicates a loan that will be taken on day 30 for a period of 180 days © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. Example of FRA I On Jan 1, Company A anticipates a need to borrow INR 10,000,000 on April 1 for a period of 180 days. Company A enters into an FRA with Bank B at 8%, with a reference rate of 6-month MIBOR + 100 basis points FRA start date: Jan 1 FRA settlement date: 90 days FRA end-of-exposure date: 270 days 90 x 270 FRA: Agreed rate 8% Reference rate 6-month MIBOR + 1% © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. Example of FRA II On April 1, 6-month MIBOR: 7.5% Reference Rate: 7.5% + 1% = 8.5% Company A will borrow in the market at 8.5% for 180 days. Agreed rate: 8% Bank B will pay the difference of (8.5% - 8%) = 0.5% of the loan amount to Company A to compensate for increased interest on the settlement date. The amount to be paid will be the discounted value of the interest differential as settlement is at the start of the loan and interest payment at end-of-exposure date © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. FRA Mechanics FRA is defined as (t1, t2) FRA, Where, t1: Settlement date t2: End-of-exposure date Period of loan: t2 – t1 days fr (t1, t2): Agreed rate r (t1, t2): Reference rate © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. FRA Payment Amount Principal amount: P Number of days in a year: (usually 360) © 2011 Dorling Kindersley (India) Pvt. Ltd.

FRA Payment Amount: Example In example, r (t1, t2): 8.5% fr(t1, t2): 8% P: INR 10,000,000 D: 90 days B: 360 days Settlement amount: © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. Settlement Payment If r (t1, t2) > fr (t1, t2), the borrower needs to pay interest higher than agreed upon, and hence the counterparty will pay the settlement amount to the borrower If r (t1, t2) < fr (t1, t2), the borrower will borrow at a lower rate than agreed upon—and hence need to pay the counterparty the settlement amount © 2011 Dorling Kindersley (India) Pvt. Ltd.

© 2011 Dorling Kindersley (India) Pvt. Ltd. Uses of FRA Corporations can lock in future borrowing rates while taking up floating rate loans or for taking short-term loans Banks can use FRAs to hedge interest rate risk due to mismatch of the maturity of assets and liabilities Banks can use FRAs to lock in borrowing costs Banks can use FRAs to cover exposure to movements in short- term rates © 2011 Dorling Kindersley (India) Pvt. Ltd.

Non-deliverable Forwards Used in the case of non-convertible currencies Instead of currency delivery at forward contract maturity, settlement will be in the form of cash © 2011 Dorling Kindersley (India) Pvt. Ltd.