Characteristic of Forward
Contract
Forward is a contract to buy or sell
of a specified currency at a future date (delivery date) at exchange rate fixed
today (Contract date). Forward contracts have legal binding and do not required
premium payment.
1.
Forward Contract not Traded
Forward contract are not traded in
the market and entered by the company and bank to meet the specific needs of
the company. Each forward contract is designed to meet the specific requirement
of the company at delivery date.
2.
No premium involved
Forward contract does not involve any
premium because it is not traded in the market rather it is entered into. it is
to be noted that premium is a basic feature of options ( which is different
from forward contract).
3.
No margin Requirement
There is no margin requirement to
entered into forward contract rather there is small fees involved for forward
contract setup. It is to be noted that margin requirement is a feature of
future contract which is different from forward contract.
4.
Physical Delivery is Requirement
Forward contracts are binding in
nature and therefore physical delivery of actual currency will be required at
delivery date. Due to this very reason the forward contract are believed to be
inflexible.
5.
Expensive
Forward contract are tailored made and therefore
are expensive than other hedging options.
Example of Forward
Contract
On ist march 2009 a company based in UK will receive an
income of $ 100,000.
|
Spot Rate
|
1.62358-
1.6429
|
|
Four month forward
|
2 – 3
Cents
|
|
Actual Rate after
three month
|
1.7200- 1.7400
|
How much sterling is received in case of forward contract?
Solution
1.
Find Buying Rate
The company will have to buy the USD and therefore will first
of future buying rate will be established.
|
Spot Rate
|
1.6429
|
|
Spread
|
.0300
|
|
Future buying rate
|
1.6729
|
2.
Apply buying rate to buy $ 100,000
|
Quantity of $
required
|
$
100,000
|
|
Buying rate
|
1.6729
|
|
Expected Sterling
= $ 100,000/1.6729
|
59,776.4361
|
|
|
|
Tip of the example
·
You
will divide with applicable rate when you will buy foreign currency
·
You
will multiply with applicable rate when you sell foreign currency
