A forward contract is a customized contract between two parties to buy or sell an asset at a price agreed upon today on a specified future date. Under forward contract, there is an obligation for the buyer to pay for what has been bought and receive delivery thereof as per the contract, and for the seller to give delivery of what has been sold and receive payment for the same.
Forward contract is actually a risk management strategy used in hedging or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In foreign exchange market both exporters and importers enter into forward contracts for limiting or offsetting probability of loss from fluctuations in the prices of currencies they are dealing in when they receive or make payment in specific foreign currency.
Forward contracts are booked by an exporter when he expects that the concerned foreign currency will be appreciated ( where the future rate is higher than the spot rate). An importer may book forward contract if he anticipate that the concerned foreign currency will be depreciated (where the future rate is lower than the spot rate) on the date or retirement of import bill.
Forward Contracts are categorized as ‘Fixed Date Forward Contracts’ and ‘Option Forward Contracts’.
Fixed date forward contract:
In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date. For example, a customer enters into a one month forward contract on 5th May with his bank to sell USD 10000, and then the customer would be presenting a bill or any other instrument on 7th June to the bank for USD 10000. The delivery of foreign exchange cannot take place prior to or later than the determined date.
Option forward contract:
The Option Forward Contract is entered into in order that the customer gets the flexibility to receive/deliver the foreign exchange on any day during a specified period. Such an arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as ‘Option Forward Contract’. The rate at which the deal takes place is known as the option forward rate. In the contract the option, the period of delivery should be specified as calendar week or calendar fortnight or calendar month. FEDAI rules require the option period of delivery to be specified as any period not exceeding one month. Contracts permitting option delivery must state first and last dates of delivery.
Suppose, on 5th May a customer enters into two months forward sale contract with the bank with option over July. It means the customer can sell foreign exchange to the bank on any day between 1st July and 31st July. In the above example, the period during which the transaction takes place is known as the ‘Option Period’. As per FEDAI rules, the option period of delivery cannot exceed one month. Further, in option forward contract, the customer has the freedom to deliver the foreign exchange on any day during the option period. The bank should quote a single rate valid for the entire option period.
Place of delivery:
All contracts shall be understood to read “to be delivered or paid for at the Bank” and “at the named place”. If the delivery of foreign exchange falls in two or more separate calendar months due to part shipments, it is advisable to book separate split contracts on the basis of the same underlying transaction.
Date of delivery:
Date of delivery under forward contract will be;
- Date of negotiation/purchase/discount and payment of Rupees to customer for bills/documents negotiated, purchased or discounted.
- Date of payment of Rupees to customer on realisation bills, for bills/documents sent for collection.
- Date or retirement/crystallisation of liability whichever is earlier in case of import bills under LC.
- Date of retirement in the case of import collection bills.
- In the case of other forward sale contracts, for remittance of surplus freight, dividend, interest / installment of foreign currency loan, NRE account balances etc. date of debit to customer‘s account.
- In the case of FCNR deposits, the date of conversion of foreign currency proceeds into Indian into Indian Rupees.
Variation in Delivery time:
It is a common experience of the bankers that often the delivery or take delivery of a fixed sum of foreign exchange under a forward contract does not take place at the agreed time on account of early delivery, Late delivery, Cancellation on the due date, Early cancellation, Late cancellation, Extension on the due date, Early extension, Late extension etc. In such cases, banks generally agree to these variations provided the customer bears the loss if any on account of these changes.
Known holiday/suddenly declared holiday
In terms of FEDAI guidelines, if the maturity date of the contract happens to be a known holiday, the contract would mature on the working day immediately preceding the known holiday. In case of suddenly declared holidays, the contract shall be deliverable on the next working day. In case of suddenly declared holiday falling on the last working day of the month known at least 2 working days prior to the settlement day, the contract shall be deliverable on the preceding day when all centers concerned are open. In case of interbank forward contract, that allows option of delivery, the buyer bank shall take up such forward contract after giving a notice of 2 working days to the seller bank.
Related articles:
Revised guidelines on exchange-traded currency deliveries
Difference between a forward contract and futures
What are the cash rate, tom rate, spot rate, and forward rate?
How does a bank charges on early delivery or cancellation of forward contracts?
Revision of position long or short in currency derivatives
