Forward contract is Hedging instrument offered by financial institutions such as banks.
Forward contract involves agreement of buying or selling of foreign currency at pre-determined rate at settlement date. Rate is determined at the time of entering into contract.
Forward contract usually requires no or little payment in advance for entering into contract.
Forward contract requires settlement on net basis for any gain or loss realised on foreign exchange.
In case of expected receipt (inflow) in foreign currency, business should enter into forward contract to sell foreign currency because selling involves outflow of foreign currency.
In case of payment (outflow) required in foreign currency, business should enter into forward contract to buy foreign currency because buying involves inflow of foreign currency.
Risk associated with inflow will be cancelled by risk associated with outflow of foreign currency, which consistent with the primary rule of hedging.
There are four scenarios possible for hedging:
- Expected receipt in foreign currency with actual increase in foreign exchange rate.
- Expected receipt in foreign currency with actual decrease in foreign exchange rate.
- Payment required in foreign currency with actual increase in foreign exchange rate.
- Payment required in foreign currency with actual decrease in foreign exchange rate.
Receipt
In case of expected receipt, loss due to decrease in foreign exchange rate will be offset by gain on forward contract and gain due to increase in foreign exchange rate will be offset by loss on forward contract.
Scenario 1 (Gain on Forward Contract)
Forward contract will result in gain if forward rate agreed is higher than market rate at settlement date. Because organization will sell foreign currency at rate higher than the rate for which foreign currency could be sold in the market. Bank will pay the difference for gain (forward rate – market rate) incurred by the organization.
Organization can then sell the receipts in foreign currency at market rate (spot rate at settlement date) in market. This way organization has fixed exchange rate at forward contract rate (market rate + gain on forward contract) at agreement date.
Scenario 2 (Loss on Forward Contract)
Forward contract will result in loss if forward rate agreed is lower than market rate at settlement date. Because organization will sell foreign currency at rate lower than the rate for which foreign currency could be sold in the market. Organization will pay difference to the bank for loss (forward rate – market rate) incurred by the organization.
Organization can then sell the receipts in foreign currency at market rate (spot rate at settlement date) in market. This way organization has fixed exchange rate at forward contract rate (market rate – loss on forward contract) at agreement date.
Payment
In case of payment required, loss incurred due to increase in foreign exchange rate will be offset by gain on forward contract and gain due to decrease in foreign exchange rate will be offset by loss on forward contract.
Scenario 3 (Loss on Forward Contract)
Forward contract will result in loss, if forward rate agreed is higher than market rate at settlement date. Because organization will buy foreign currency at rate higher than the rate for which foreign currency could be bought in the market. Organization will pay the difference to the bank for loss (forward rate – market rate) incurred by the organization.
Organization can then buy foreign currency at market rate (spot rate at settlement date) from market to pay suppliers. This way organization has fixed exchange rate at forward contract rate (market rate + loss on forward contract) at agreement date.
Scenario 4 (Gain on Forward Contract)
Forward contract will result in gain, if forward rate agreed is lower than market rate at settlement date. Because organization will buy foreign currency at rate lower than the rate for which foreign currency could be bought in the market. Bank will pay the difference for gain (forward rate – market rate) incurred by the organization.
Organization can then buy foreign currency at market rate (spot rate at settlement date) from market to pay suppliers. This way organization has fixed exchange rate at forward contract rate (market rate – gain on forward contract) at agreement date.
