1. Forward contracts simplified
By C.E.S Azariah,
CEO, FIMMDA

2. Following slides illustrate Forward Contract pricing for USD/INR for Exporters by Banks

4. EXPORTER’S DILEMMA
If after 1 year: Exchange Rate of 1 USD = Rs Exporter gets USD x = Rs 290 per T.Shirt Cost of T-Shirt = Rs 380 Loss per T- shirt = Rs 90

5. If after 1 year : Exchange Rate of 1 USD = Rs 49
If after 1 year : Exchange Rate of 1 USD = Rs Exporter gets USD x = Rs 490 per T- Shirt Cost of T-Shirt = Rs 380 Profit per T-Shirt = Rs 110

6. EXPORTER’S DECISION
I am in the business of manufacturing T-Shirts, and I am satisfied with my profit margin of Rs 10/= per T-Shirt.
I need a protection from business losses due to USD Exchange Rate fluctuations.

7. EXPORTER APPROACHES HIS BANK
Request the Banker for a Quote (RFQ) for getting an Exchange Rate for USD valid as on 1 year hence (forward rate).
Exporter undertakes to deliver X amount of USD , being the invoice amount of his T-Shirt exports, to the bank, one year hence, once his export of goods is completed, invoiced, and USD remittance received from foreign buyer.

8. BANKER’S DILEMMA
The Exporter is asking Rupees (one year hence) in exchange for USD, which the Exporter will deliver after 1 year .
The Banker can get Rupees to deliver to the Exporter, only if he sell the USD (acquired from the exporter) in the market.
If the Exchange Rate of USD vs Rs remains fixed, for one year, it will be very easy for the Banker to quote a rate, but then, the Exporter’s Dilemma would not arise !
The Exchange Rate fluctuations , therefore, create a “Dilemma” for both the Exporter and the Banker !

9. BANKER IS FACED WITH SIMILAR DILEMMA AS THE EXPORTER
If the Banker quotes today’s Exchange Rate plus his profit i.e.: 1 USD= Rs less Rs 0.05 = Rs (contracted rate) (principle of Take More, Give Less), I . After 1 year : If 1 USD = Rs Bank delivers ………….. Rs (contracted rate) Bank receives ……………. Rs ( by selling the USD acquired from the Exporter after 1 year) Loss per USD = Rs 9.95.

10. II After 1 year :
If 1 USD = Rs 49.00
Bank delivers ……………..Rs to Exporter at Contracted Rate
Rank received …………. Rs (by selling the USD acquired from the exporter )
Profit per USD ………….RS 10.05

11. BANKER’S DECISION
I am in the business of banking (borrowing and lending), and buying and selling financial products.
I am satisfied with my profit margins of ___ %, and cannot afford unexpected losses.
I will use my expertise in borrowing and lending, purchase and sale of foreign currencies vs Indian Rupees to deliver what the Exporter wants

18. ON DUE DATE
I. If 1 USD = Rs (a) Does the Banker make a profit of Rs 9.80 Contracted Rate with Exporter: 1 USD= Rs Exchange Rate on Due Date 1 USD=Rs Rs 9.80 Obviously NO – because the Banker repays the loan of USD Interest with the USD received from the Exporter .

19. On due date (contd) (b) Does the Exporter make a loss of 9.80 ?
The Exporter’s Decision was to protect his business profit of Rs 10.00, which he has done by delivering the USD at the contracted rate of 1 USD= Rs
The Exporter suffers an “Opportunity Loss” by protecting himself against all Exchange Rate fluctuations.

20. On due date (contd) II . If 1 USD = Rs. 29.00
Does the Banker lose Rs by taking delivery of the USD at contracted rate of 1USD= Rs ?
Contracted Rate USD = Rs
Market Rate on due date USD = Rs Rs
Obviously NO – because there is no sale of USD on due date.
The Banker sold the USD on the contract date at 1 USD = Rs
The dollar received from the exporter goes towards liquidating the USD borrowed.

21. On due date (contd)
II (b) Does the Exporter gain Rs by delivering the USD at contracted rate of 1USD = RS 39.20, when the market rate is Rs on due date ? Obviously NO – because on the contract date itself the Exporter locked the rate at which he would sell the USD to the bankers on the due date. The Exporter has protected himself against the adverse movement of the USD

22. On Due Date (contd)
I. What happens if the Exporter does not have the dollars to deliver on the Due Date, and asks the Banker to cancel the contract ?
The results would be the same as the scenarios shown for cancellation of contracts after 3 months .
If the USD rate is lower than contracted rate, the Exporter receives some money on cancellation . Why ?
If USD rate on due date is higher than contracted rate, the Exporter has to pay the cost incurred by the banker on cancelling the contract. Why ?