(This post explains how bank calculate early delivery or cancellation losses of forward contract with examples)
Whenever an exporter wants to undertake a Forward (Sale) Contract against his receivable he will do so with a rough idea of the time period in which he can expect his buyer to send the payment. Forward contract is booked expecting that by the time payment is receive, value of currency would be appreciated. Similarly an importer may book forward contract in anticipation of value of the currency concerned will be depreciated by the time of retirement of import bill.
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. As per FEDAI guidelines, it is optional for the bank to accept or give early delivery or extend the contract. In such cases usually the bank may accede to the request of the customer provided the customer agrees to bear the loss incurred by the bank, if any.
Buying rate and selling rate:
Buying rate of a currency is the rate at which the market is willing to buy a foreign currency from a bank. Selling rate is the rate at which market is willing to sell a foreign currency on a suitable maturity date. When a bank customer wants to sell foreign currency (Ex: export receivable) to the bank, then the bank needs to sell that foreign currency in the inter-bank market at buying rate. In the same way when a customer wants to buy foreign currency from the bank (Ex: for retirement of import bills) bank needs to buy from the market at inter-bank selling price to provide foreign currency to the importer. Of course in the process bank would book its profit on each of this transaction taking exchange (profit) margin on its buying/selling rates of a foreign currency offered to the customers. India is practicing ‘Direct Quote’ system. Therefore the maxim practiced in India is “Buy Low Sell High” which means while buying foreign currency bank pays less amount of Rupees to the customer and while selling bank would collect more amounts of Rupees from the customer.
Rate at which cancellation is to be effected:
Purchase contracts shall be cancelled at T.T. selling rate of the contracting Bank (Authorised Dealer)
Sale contracts shall be cancelled at T.T. buying rate of the contracting Bank (Authorised Dealer)
Where the contract is cancelled before maturity, the appropriate forward T.T. rate shall be applied.
Early delivery:
When a customer of the bank requests early delivery of a forward contract, i.e., delivery before its due date, it is known as early delivery. The charges for early delivery will comprise of: (i) Swap difference (irrespective of whether an actual swap is made or not); (ii) Interest on outlay of funds (not below the prime lending rate of the respective bank on outlay of funds); and (iii) Flat charge of (or handling charge) Rs. 100 (minimum per request) as per FEDAI rules.
Interest calculation:
Interest at a rate not below the prime lending rate of the respective bank on outlay of funds by the bank for the purpose of arranging the swap shall be recovered in addition to the swap cost in case of early delivery of purchase or sale contracts and early realization of export bills negotiated. While charging interest on the amounts of funds outlaid shall be arrived at by taking the difference between the amount at original contract rate and the amount at the rate at which the swap could be arranged. If such a swap leads to inflow of funds, the amount shall be arrived at as above and interest shall be paid to the customer in the discretion of banks at the appropriate rate applicable for term deposits for the period for which the funds remained with the bank deposits. Payment of swap gain to a customer shall be made at the beginning or at the end of swap period as per the bank’s own policy in this regard.
Calculation of various charges on early delivery:
Example: Forward purchase contract has been booked by an exporter for USD 10000/ @ 66.85 delivery 3rd month. However, the documents are delivered in the first month. Following are the market rates.
Spot Rate on date of contract 66.30/66.45
Spot rate (on the date of delivery) 1st month- Rs. 66.40/ 66.50
Forward Rate 2 months (on the date of delivery)- Rs. 66.70/ 66.80
Solution:
In the above example, the early delivery has compelled the Bank to effect the following transactions:
Calculation of Swap difference: The difference between Transaction nos. 1 and 2 is the swap difference In the swap above, the Bank has to sell the foreign exchange received at Rs.66.40 to the market and purchase the same amount two months forward at Rs. 66.80 from the market (Since the customer will not be in a position to deliver the foreign exchange as contracted in the third month, the Bank has to honour its sale transaction commitment and hence a forward purchase for 2 months to coincide with the original maturity period @ 66.80 ) and hence the swap loss is 40 paise per USD which amounts to Rs.4000/- for USD 10000/- . This loss of Rs.4000/-is to be recovered from the customer.
Calculation of Interest on outflow of funds:
Calculation of Interest on outflow of funds:
In the above example, Customer was paid at contracted rate @ Rs.66.85 for USD10000/- is Rs.668500.00 as per original contract. The bank has an immediate outflow of funds, as Rs.668500.00 is paid to the Customer. The inflow of funds from the spot sale is only Rs.664000.00. Hence, there is an outlay of funds (Rs.668500.00 – Rs.664000.00) of Rs.4500/-. (Difference between the amounts paid and amount received).Here; interest on difference of Rs.4500 shall be recovered from the customer at a commercial rate of interest from the date of delivery to the date of maturity of original forward contract. (i.e. interest for 2 months at a commercial rate fixed by the bank).
Note: Cash outlay arises when the swap spot selling rate is lower than the contract rate. If the foreign currency is at a discount in direct contrast to the above example, swap difference shall be paid to the customer.
In case of EARLY DELIVERY IN SALE CONTRACT we have to substitute spot purchase by spot sales and forward sale substituted by forward purchase (coincide with the original maturity period) in the above example for calculation of the swap difference. Here cash outlay arises when the swap spot buying is higher than the contract rate.
CANCELLATION BEFORE MATURITY:
Example: A forward purchase contract has been booked by an exporter for USD 10,000/ delivery 3rd month @ Rs.67.40. The customer asks for cancellation after a month on which date the spot rate is Rs 67.05/ 67.30 and 2 months forward rate Rs.66.80/ 66.95
Exchange difference would be the difference between:
The exchange difference of Rs.4500/ is to be paid to the customer.
In the above example if 2 months forward rate is 67.80/67.95 then swap difference is 674000-679500= -5500/-. The difference of Rs.5500/- would be recovered from the customer.
(For the purpose of illustration exchange margin is ignored).
CANCELLATION OF OVERDUE CONTRACT [ON OR BEFORE 3rd DAY AFTER MATURITY]:
In the above example, the original contracted rate was USD = Rs.67.40
In case the spot TT selling rate on the 3rd day after maturity is USD = Rs.67.30
Bank receives original rate USD = Rs. 67.40 x 10000 (original cost) Rs.674000.00
Bank pays Spot TT selling rate is 67.30 X 10000 (cover cost) Rs.673000.00
Gain Rs.1000
Exchange difference of Rs.1000/- is the gain, which will not be paid to the customer.
In case the spot TT selling rate on the 3rd day is Rs.67.95
Bank pays Rs.67.95 X 100,00 Rs6,79,500 for acquiring 10000 Dollars
Bank receives original rate @ Rs.67.40 x 10000/-= Rs674000.00
Difference is Rs.5500.00
The Loss of Rs.5500.00 would be recovered from the customer.
Related articles:
Revised guidelines on exchange-traded currency deliveries
What is a currency derivative?
Difference between a forward contract and futures
What are the cash rate, tom rate, spot rate, and forward rate?
Revision of position long or short in currency derivatives
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