Forward Exchange Contract Example
A Forward Rate may be calculated either for a fixed time ahead, or for a period of time. Usually up to three months from the time of the contract but it could be longer. For example, a contract made on 1st November which was two months forward fixed would become due on 1st January. However, it may be that the exporter is not sure when the buyer will make payment and, therefore, when he will wish to sell foreign currency to the bank.
In this instance he will want to retain some flexibility over the date of the completion of the contract with the bank. He will want to have what is known as an ‘option dated forward contract’ so that within certain agreed dates he may choose exactly when he sells the money to the bank.
It is important to note that under an option dated forward contract there is no choice about whether to sell or buy the money or not. Once the contract is made it is binding and the only choice is over the exact time of completion. In the example of a two months fixed contract given above the date on which the currency had to be exchanged was 1st January.
If the exporter wanted some flexibility he could choose to have a three-month forward contract with an option over the second and third month. The various forward rates are calculated by referring to the spot rate, either bank selling or bank buying, and then using the forward rates to calculate the contract price.
The forward rates will be quoted as being at a premium or a discount which reflects the difference in interest rates on the interbank market rather than what the bank regards as the possible exchange rates in the future. For example currencies with lower interest rates than the £ sterling will be said to stand at a premium while those with higher interest rates will be at a discount.
Forward Exchange Contract Example: In the example below we see the US dollar being quoted as a premium.
Spot Rate £1 = $1.5040 – $1.5120
One Month .10c – .05c pm
Two Months .15c – .12c pm
Three Months .25c – .18c pm
To calculate a forward rate the bank will deduct the appropriate premium from the spot rate. So based on the above figures the forward contract rates would be as follows: –
Bank Selling Bank Buying
One Month $1.5030 $1.5115
Two Months $1.5025 $1.5108
Three Months $1.5015 $1.5102
As the currency is becoming more expensive you will get fewer dollars for sterling if you are buying from the bank but more pounds when the bank is buying dollars from you.
Now to compare this with an example of the dollar being quoted at a discount:
Spot Rate £1 = $1.5040 – $1.5120
One Month .03c – .08c dis
Two Months .10c – .15c dis
Three Months .17c – .23c dis
To calculate the forward rate in the case of a currency that is becoming cheaper, the appropriate discount will be added giving the following forward rates.
Bank Selling Bank Buying
One Month 1.5043 1.5128
Two Months 1.5050 1.5135
Three Months 1.5057 1.5143
As the currency is becoming cheaper when the bank sells you dollars in the future you will get more for your pounds, but if they are buying dollars you will get less in the future than at the spot rate. If the contract is a forward option then the bank will have the choice of quoting either the rate at the beginning or the end of the option period.
For example, if you had the forward option contract mentioned above, three month forward with the option over the second or third month, the rate could either be the one month rate (the rate at the beginning of the period) or the three month rate (the rate at the end of the period). If the currency is at a premium then the bank will sell at the rate at the end of the period and buy at the rate at the beginning of the period.
If, on the other hand, the currency is at a discount the bank will sell at the rate at the beginning of the period and buy at the rate at the end of the period. The bank will always buy or sell at a rate it finds most advantageous.
The point is the customer will know exactly what the rate will be when he makes the contract and so has stability and certainty about what he will receive in the future, and he may well be able to adjust his price to the contract exchange rate.
To sum up, the contract rate is set when the contract is made. The option in the contract is there so that the customer may choose exactly when, during the option period, he will buy or sell the currency concerned. Once the contract is made it must be completed.
The four main rules to remember are:
1. The bank buys high.
2. The bank sells low.
3. A discount is added to the spot rate.
4. A premium is deducted from the spot rate.
Also since the bank is in the business of making a profit, like any other business, it will set the option contract rate which is most advantageous to the bank.