1. Foreign Exchange Forward Contracts
By Tarun & Sindhu

2. Trailer
• Hedging and its importance
• Terms used in Foreign
Exchange Market
• Meaning of Foreign Exchange
Forward Contract
• Characteristics
• When Foreign Exchange
Forward Contract?
• Closing of Forward Contracts
• Foreign Exchange Forward
Contracts and Accounting
Standards
• Evidence for use of Hedging
in India

3. HEDGING AND ITS IMPORTANCE
• Hedging means reducing or controlling risk.
• Risk includes transaction risk, translation risk, economic risk and
political risk.
• So in case of a forward contract, we would be fixing the forward
rate which would hedge the position in the future.

4. Terms used in Foreign Exchange
Market
1. Bid Rate
– The rate at which the bank buys a currency.
2. Ask rate
– The rate at which the bank sells a currency.
If a Banker provides the following quote – Rs/$ 45 – 48,
45 48
Bid rate Ask rate

5. Terms used in Foreign Exchange
Market
1. Spread
– Difference between Bid rate and Ask rate.
2. Spot rate
– The rate quoted in current scenario.
3. Forward rate
– The rate contracted today for exchange of
currencies at a specified future date.

6. Meaning of Foreign Exchange
Forward Contract
Foreign Exchange Forward Contract
Performance at a
Exchange of
future date at
Foreign Currency
forward rates

7. Characteristics
 It is a contract for the purchase or sale of a specified quantity
of a specified currency.
 Price is agreed today.
 Performance is at a specified future date.
 Both parties are obliged to perform.
 The party that buys the specified currency is said to have a
long position.
 The party that sells the specified currency is said to have a
short position.

8. Other Relevant Points
 There are 3 standard periods of time in a forward
market i.e., 1 month, 3 month and 6 month forward.
 The length of time upto which one can stretch
forward depends upon demand levels.
 In India, forward rates are available for 6-month
periods and can be rolled over.

9. Should you take a Forward Cover?
 Deciding whether to take a forward cover or
not depends on the type of person.
 In other words we need to see whether the
person is an importer or an exporter.
 Another important thing of concern is that the
banker ALWAYS WINS.
 Also it depends upon the relationship between
the forward rate and expected spot rate.

10. Consider the following example:
 Exporter:
You are going to receive 1,00,000 USD 3-months from today.
You fear that the ` will appreciate against $ and hence, you
may receive less ` 3-months later. So you enter into a forward
contract and freeze the proceeds. What should you do?
 Importer:
You are going to pay 1,00,000 USD 3-months from today. You
fear that the ` will depreciate against $ and hence, you may
pay more ` 3-months later. So you enter into a forward
contract and freeze the payments. What should you do?
>> You should prefer that option which gives you high inflow in
the case of exporter and lower outflow in the case of imports.

11. Selection criteria for forward contract
Relationship Exporter Importer
Forward Rate > Expected Forward Cover Exposed
Spot Rate
Forward Rate < Expected Exposed Forward Cover
Spot Rate

12. How to Close a Forward Contract?
A Forward Contract can be closed either:
 On the due date of settlement of the forward
contract
(OR)
 On any date prior to the date of settlement.
Roll
Over
Honor Cancel
Closing out
can be
done in
three ways:

13. Honoring a Contract
 Honoring a contract means performing the
contract entered into at the end of the
stipulated time period.
Importer Exporter
Sell the Foreign
Buy the Foreign
Currency on
Currency on
agreed date and
agreed date and
rate
rate
 So further no action would be required other
than the above.

14. • Sometimes the importer or
exporter decides for an early
honor.
Early Honor • In such a case, following
procedure needs to be followed:
Early Honor Spot Forward
Importer Buy Sell
Exporter Sell Buy

15. Rolling over the Contract
It means extending the period of the contract either
on or before the due date.
On Due Date:
Roll Over on Due Spot Forward
date
Importer Sell Buy
Exporter Buy Sell

16. Continued….
• Before Due Date:
Early Roll Over Forward Forward
Importer Sell Buy
Exporter Buy Sell

17. Cancel the Contract
Cancelling a forward contract means revoking the
performance. This would be done by taking an
opposite position.
• On Due Date:
On Due Date Spot
Importer Sell
Exporter Buy

18. Continued…
• Cancel Early:
Cancel Early Forward
Importer Sell
Exporter Buy

19. FOREIGN EXCHANGE FORWARD
CONTRACTS AND ACCOUNTING
STANDARDS
Foreign Exchange Forward Contracts
For Hedging For Trading or Speculation

20. As per Para 37 of AS-11, Any risk associated with changes in exchange
rates may be mitigated by entering into forward exchange contracts.
Two things arise in
such contracts
Premium or Exchange
Discount Difference
Amortized to P & L Written off to P & L
Account over the Account as and
contract period when it arises

21. Continued…
 Premium or Discount
 = Difference b/w exchange rate on date of inception and forward
rate as per contract.
 Exchange Difference
 = Difference b/w exchange rate on reporting date and rate on
date of inception.
Consider the following example:
Mr.A imports a plant worth 1,00,000 $ from USA on 01.06.2008.
Payment to be made after 2 months. He enters into a 2-months
forward contract on 01.06.2008.
Forward rate booked – Rs.45.40
Exchange rate on 1.6.2008 – Rs.45
Exchange rate on 30.6.2008 – Rs.46
Exchange rate on 31.7.2008 – Rs.47.50

22. Forward Exchange
Premium Difference
45.40 - 45 47.50 - 45
Deferred Revenue
Gain
Expenditure
Amortized over 2- Credited to P & L
months i.e., at the Account on
end of every month 31.07.2008

23. Date Particulars Amt (in Rs Lakhs) Amt (in Rs Lakhs)
01.06.2008 Purchase A/c Dr 45
To Mr.X 45
(Being purchase of goods)
01.06.2008 Forward Contract Receivable Dr 45
Deferred Premium Dr 0.4 45.4
To Forward Contract Payable
(Being forward exchange contract entered into)
30.06.2008 Difference in Exchange Dr 1
To Mr.X 1
(Being exchange loss on foreign currency creditors)
30.06.2008 Forward Contract Receivable Dr 1
To Exchange Gain 1
(Being booking of exchange gain on forward exchange contract)
30.06.2008 Profit & Loss A/c Dr 1.2
To Deferred Premium 0.2
To Difference in Exchange 1.0
(Being loss transferred to P & L A/c)
30.06.2008 Exchange Gain Dr 1
To Profit & Loss A/c 1
(Being gain transferred to P & L A/c)
31.07.2008 Forward Contract Receivable Dr 1.5
To Exchange Gain 1.5
(Being gain on forward contract)
31.07.2008 Difference in Exchange Dr 1.5
To Mr.X 1.5
(Being exchange on settlement date)
31.07.2008 Forward Contract Payable Dr 45.4
To Bank A/c 45.4
(Being payment made to bank on settlement date)
31.07.2008 Mr.X A/c Dr 47.5
To Forward Contract Receivable 47.5

24. Forex Forward Contracts for Trading or Speculation
 When foreign exchange contracts are entered
to earn profit by trading or speculation, the
accounting treatment shall be different since
the object is to gain rather than hedging.
 As per Para 39 of AS-11, premium or discount on
such forwards need not be recognised.
 It means that the value of contract is marked to
its current market value.

25. Outstanding Foreign Exchange Contracts of Banks
Outstanding Foreign Exchange Contracts of banks (In Billions)
SL Item March 2007 March 2008 March 2009 December 2009
No
INR USD INR USD INR USD INR USD
Foreign
1 exchange 29,254 671.12 55,057 1,377.46 50,684 994.78 36,142 774.25
contracts
Forward forex
2 24,653 565.57 47,360 1,184.89 44,669 876.72 31,190 668.17
contracts

27. Advantages
 Certainty - secure income or stabilize cost
 Protection
 Cash flow modification
 Maximizing Share Holder Value

28. Disadvantages
 While forward contracts can fix anticipated revenue
or cost, they cannot minimize cost or maximize
revenue.
 Fixed Rate.
 Performance.
 Liquidity.
 Tailor-made contracts-often suffer from poor
liquidity.