Last week we took you through Forward derivatives and explained you the concept of the forward contracts and looked at the way they work. In this article, we will be taking you through an interesting topic under forward contracts- deliverable and non-deliverable contracts.
But before that, let’s start with the overview of a forward contract.
A forward contract is an agreement between a buyer and seller to buy or sell an underlying asset at a pre-determined price and at a pre-determined future date.
Few Terminologies used in Forward contract:
; Bid Rate: It is the rate at which the banker is ready to buy from you (Let’s say AUD against USD).
; Ask Rate: It is the rate at which the banker is ready to sell AUD against USD from you.
The thing to remember here is that the Ask rate would be higher than the Bid rate as the banker would buy at a lower rate and sell the currency at a higher rate to make a profit.
Suppose in the banker’s screen, if the Bid rate shows A$1.4550 and ask rate is A$1.4567, it means that the bank is ready to buy 1 USD by paying A$1.4550 while ready to sell 1 USD for A$1.4567.
; Spot Rate: Spot rate is the prevailing rate of exchange in the market.
; Forward Rate: Forward rate is the rate at which you would like to enter into the forward contract. It could be either three months forward, nine months forward, 12 months forward or 15 months forward, depending on the requirement.
In case of both spot and forward rate, there would be a bid and an ask rate.
Now let’s consider two cases while you sign the forward contract:
Case 1: At t=0, the spot rate of AUD against USD is A$1.45, and you enter into a three months forward contract, where the bank is ready to buy USD from you at A$1.48.
Three months down the line, at the time of settlement, now the spot rate becomes A$1.50, then in this case, you would be making a loss of A$0.02 (A$1.50-A$1.48).
Case 2: Same as case 1, but with a slight difference. In this scenario now, after three months, the spot rate becomes A$1.43, then you would be making a profit of A$0.05 (A$1.48-A$1.43).
Thus, the formula to calculate the profit or loss can be obtained subtracting the spot rate at the time of settlement (St) from the forward rate (Fo) that was signed while entering into the contract, i.e. F0-St.
If F0-St is positive, you make a profit else you end up making losses.
There are two types of forward contract:
; Deliverable Forward Contract: It is a contract wherein you have something to deliver.
; Non-Deliverable Forward Contract: In NDF contract, there is nothing to deliver instead there is a net settlement.
Deliverable Forward Contract
Deliverable Forward Contract, as the name suggests, is the contract where there is something to deliver. More precisely, in a deliverable forward contract, the USD/AUD forward contract would result in a physical exchange of USD for equivalent AUD.
Some points to remember:
In currency pair USD/AUD, the first currency is the base currency while the second currency is the quote currency. Thus, currency pair USD/AUD represents how much base currency is required to get the quote currency.
Importance of considering forwards:
Companies having global exposure trade in foreign currency, and we are well aware that exchange rates of major currency pairs can change by the milliseconds. Thus, it creates an unpredictable environment for these companies.
Thus, entering into forward contract helps in eliminating the volatility by ‘locking in’ an exchange rate today based on the current spot rate for the transaction to take place at a future date.
How are forwards computed?
We are unaware of the exchange rate in future, and it cannot be predicted. The only rate which the investors know is the historical rate or the current rate, which is known as the spot rate or the spot price. While calculating forward, two aspects are calculated.
; The present value of the money: The present value is important to consider because it is not necessary that it will be the same amount which the investor requires.
Present Value= The sum required for the Forward/ (1+(duration of the contract/365) x interest rate)
; The future value of the money: It refers to the money that could be safely invested during the particular time frame and earn interest.
Let’s consider an example to calculate the present value of the money required by a company ABC Limited in Australia which needs US$100,000 in 3 months (90 days). Assume risk-free interest rate provided by the US to be 0.12%. Then using the above formula, the present value of this amount would be:
= 100,000/ (1+(90/365) x (0.12/100))
=100,000/1+(0.246 x 0.0012)
Now we have derived the present value of US$100,000, which is US$99,970.49. The current AUD/USD spot rate is 0.69. Thus US$99,970.49 is equivalent to A$144,884.7681.
Let say there is a financial institution named XYZ ltd who would borrow A$144,884.7681 to fund ABC Ltd from another bank at a rate of 3%. So XYZ Ltd will have to repay
Amount = 144,884.7681 + [(144,884.7681 x 3 x 90)]/ (365) x 100
(The value is derived using the simple interest formula)
Now the next question is that what rate should be the forward rate which XYZ Ltd will offer ABC Ltd. The answer is
Forward rate = US$100,000/A$145,956.52
Non-Deliverable forward contracts (NDF contract):
A non-deliverable forward contract is a foreign exchange agreement where one of the currencies involved in the contract cannot trade freely in the forex market. The organisations which enter into the NDF contract seek to hedge the currency risk when doing business in nations whose money is not easily traded.
NDF contracts are generally short-term agreement amongst two parties in which the difference between the spot price exchange rate on the settlement date of the contract and the earlier decided exchange rate is settled for a notional amount of money. Non-Deliverable Forwards are generally priced & settled in USD (Base currency).
An NDF contract is generally executed offshore, i.e. location beyond of one's national boundaries of untraded currency.
An example of NDF transaction: If the currency of country A is restricted from moving offshore, then, in that case, it would be difficult to settle the transaction in that currency from someone outside the restricted nation. However, the parties involved in the transaction can settle the NDF by converting the gains & losses on the agreement to that currency that can trade easily. The counterparties can pay the profit and losses in the freely traded currency.
Terminologies used in NDFs:
NDF Rate: It is the forward rate at which the contract is agreed upon.
Trade date: It is the date at which the agreement initiates.
Reference Rate: It is the spot exchange rate in the future. It is the date on which the NDF deal matures.
Fixing date: It is the future date in which the reference rate is fixed.
Cash settlement: It is the difference between the NDF, and the reference rate based on notional.
Settlement date: Date of cash settlement.
Cash Flows in NDF= (NDF rate- Spot Rate) x Notional amount
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