Foreign Exchange Contracts: Spot and Forward Contracts

9.1: Introduction:

Forex rates can be quoted as spot or, forward contracts. When buyers and sellers agree to trade at the current exchange rate for immediate delivery, it is known as spot transaction or cash transaction. The word “immediate” has different meaning in this case. It can “ at that instance” can go upto maximum of two days.

In forex market parlance, the trade date is the day on which both parties agree to buy and sell. The settlement date/value date is the day on which funds are actually transferred between the buyer and seller. On settlement/value date, the buying or selling actions will be realized by settlement of payment and receipt. Depending upon the gap between trade and value date, spot forex trading can either be categorized as cash, tom or spot transaction.

9.2: Spot forex transactions:

When a person goes to money changer/bank and buys one currency by paying another currency is an example of spot transaction (or spot delivery) and the rate quoted by the money changer/bank is the spot rate. For example, in India, some hotels buy or sell foreign currency over the counter. Normally the hotel/antique shops will have a display board mentioning different INR rates for different currency. Any guest visiting the hotel can buy or sell foreign currency at the rate displayed on the board. This is an example of cash transaction where the trade date and settlement date coincide.

Similarly in the interbank market, banks & financial institutions buy and sell currencies at a rate prevailed on the trade date. However, the actual settlement for the agreed amount may take place on T+1 or latest by T+2 days. With the advance in communication technology and electronic fund transfer mechanism, settlement date is narrowing down to trade date.

In India, the delivery under a spot transaction can be settled as ready/cash, Tom or Spot as given in Table 9.1.

Table 9.1: Different types of delivery/settlement under spot transaction.

Ready or cash              The transaction to be settled on the same day

Tom                                   The delivery of foreign exchange to be made on the day next

(tomorrow) to the date of transaction.

Spot                                    Delivery of foreign exchange would take place on the 2nd working

day from the trade date.

9.3: Roll over of Spot/Tom contract:

Many-a-times, settlement for spot/tom transactions may not happen on the T+1 or T+2, but gets rolled over. In a typical spot/tom transaction, actual delivery of one currency and receipt of other currency happens between two parties. However, most forex traders are speculators. They do not trade with the intention of delivering (the currency they have sold) or receiving currency (the currency they have bought), but wants to make profit from speculation. Hence, forex brokers allow these speculators to rollover the contracts. Rollover delays the actual settlement of the trade and it goes on until the trader closes its position.

For deferring the settlement, forex brokers pay or receive interest from the trader. A trader receives interest on the currency that has been bought and pays interest for the currency that has been sold. Interest is calculated every day i.e, even for weekends. Depending on the prevailing interest rate in the respective currencies, net interest is either added or subtracted from traders account. This goes on until the trader squares up his open position. By providing rollover facilities, forex brokers also earn significant brokerage fee.

For example, on Day 1, a trader has entered into a spot transaction to sell USD 1000 to a forex broker and receive INR 47680. In other words, the trader sells USD and buys INR. On the settlement day, (on Day 3), the trader should deliver USD 1000 and take INR 47680. However, both the trader and the broker agree not to settle but defer the settlement by another two days. Hence, on Day 5, the trader pays USD 1000 and receives INR 47680.

By deferring the settlement, it can be understood that the trader has given a loan of INR 47680 to the broker. Simultaneously, the broker has given a loan of USD 1000 to the trader. Hence both owe each other interest for 2-days.

Hence, the trader pays interest rate on USD 1000 for two days. Similarly, the broker pays interest rate on INR 47680 for two days. The interest payment and receipt is netted off. After two days, either the trader or the broker pays interest rate differential.

For providing this roll over facilities, the brokers charge different types of margins. Forex brokers and traders enter into an agreement that forms the basis for the rollover facility provided by brokers. The Box 9.1 highlights the policy statements regarding rollover and interest rate for rollover spot transaction of iFinixforex brokers.

Box 9.1: Rollover & Interest Policy for spot forex trades. Source: http://www.ifinixforex.com/2policy_rollover_interest.html

iFinix Forex policy statements provide our clients with the utmost in transparency and client service in order to maximize their Forex trading experience.

Rollover & Interest Policy

In the spot forex market trades settle in two business days. If a trader sells 10,000 Euros on Tuesday, the seller must deliver 10,000 Euros on Thursday unless the position is held open and "rolled" over to the next value date. As a service to our traders, iFinix Forex automatically rolls over all open positions to the next settlement date at 17:00 Eastern Time.

Rollover or "cost-of-carry" involves the applying of a daily debit or credit to a trading account based on positions held open at 17:00 Eastern Time and on the interest differential between the two currencies in the pair(s) being traded. In the majority of cases, if a trader is "short" the currency bearing the higher interest rate then their account will be debited, if they are long then their account will be credited. For example, a short USD/JPY position will incur an interest charge as one is effectively "short" US Dollars and "long" Japanese Yen. Dollar short-term interest rates are currently at 3.5% while Yen rates are around 0.5%, a negative 3% difference. This interest differential forms the basis of the daily premium debit/credit which is applied to all open trades at 17:00 Eastern Time, Monday through Friday each week.

 Let us go back to our example of forex trader and forex broker. The trader has given a loan of INR 47680 and taken a loan of USD 1000. Suppose interest per annum in INR is 8% while that of USD is 4%. The trader should receive INR interest for two days and pay USD interest for 2 days. Hence the trader’s receipt would be (INR 20.9) and payment

would be (USD 0.2191). Suppose the INR/US$ rate is INR 47.75 on day 2. Trader’s payment in INR terms is INR 10.465. With netting off the trader receives INR10.435.

Forex rates can be quoted as spot or, forward contracts. When buyers and sellers agree to trade at the current exchange rate for immediate delivery, it is known as spot transaction or cash transaction. The word “immediate” has different meaning in this case. It can “ at that instance” can go upto maximum of two days.

In forex market parlance, the trade date is the day on which both parties agree to buy and sell. The settlement date is the day on which funds are actually transferred between the buyer and seller.

9.4: Forward forex transactions

In a forward contract both parties enter into a contract on a given day and lock in a fixed rate on specific future date. In such types of contract, the terms of the purchase (buy or sell) are agreed up front (trade execution date) but actual exchange take place on a date in the future (maturity date). On the maturity date, both parties exchange the pre-negotiated rate. For example, an Indian company which is likely to earn foreign currency i.e, Euro on account of an export order after one month, may enter into a contract today ( trade execution date) to sell Euro and receive Indian Rupees after 1 month ( maturity date). The rate is fixed on the trade date and the rate is be known as Fwd- 1 month rate.

Suppose on trade date, the Indian exporter agrees to sell EURO 1000 and receive INR 72450. On the maturity date, he delivers EURO 1000 and receives INR 72450. Such types of forward contracts are known as outright forward contracts (OFTs).

The OFT exchange rate are quoted as differentials that is at a premium or discount from the spot rate. For example, if the base currency earns a lower interest rate than the term currency, then the base currency will trade at a forward premium or above the spot rate. More details about forward premium and discount aspects are discussed in Session 14.

As forward contracts are OTC contracts, there are many variants to it. Forward contracts can be many types depending on the rigidness associated with the maturity date. In a Fixed Maturity Contract, the maturity date is fixed. The payment and receipt happens on the maturity date. Partially Optional Contracts provide some flexibility. In such type of contract, there are three dates, trade execution date, option start date and maturity

date. On the trade execution date, two parties agree to exchange and the rate of exchange is fixed. In addition, the parties can settle the transaction any time during the option start date and on before maturity date. In other words, in this contract, the maturity date spans across days rather than a single day. In Fully Optional Contract, the contract may end anytime during the life of the contract i.e, anytime during trade execution date and maturity date. Figs.9(a), 9(b) and 9(c) graphically represents fixed maturity contract, partially optional contracts and fully optional contract respectively. Like the spot contracts, in forward contracts, the actual settlement happens within two-business day from the maturity date.

Execution		Maturity
Date		Date

Fig 9(a) Fixed Maturity Contract

Execution		Option start		On or Before
Date		Date		Maturity Date

Fig 9(b) Partially Option Contract

Execution		Option start		On or Before
Date		Date		Maturity Date

Fig 9(c) Fully Optional Contract

Almost all banks provide the forward contracts to their clients. The forward contract duration can go as long as 2 years into future. There is no standard clause regarding the duration of the forward contract. As these are OTC contracts, as long as both parties agree, forward contract maturity can be of any duration.

The following example highlights this aspect. On Day 1, an Indian importer had entered into a forward contract with a bank to buy USD after 3 months. However, after 15 days of entering the forward contract, the importer wants to shorten the contract duration as it has to prepay USD to the US company for some reason. The importer asks the bank to predeliver the contract. The bank may quote an amended forward rate. If the exporter agrees with the new rate, then the old contract is cancelled and some fee charged.

Similarly forward contract maturity date can be extended. If an importer wants to extend the maturity date, the bank still fulfills the commitment and delivers the USD to the importer and receives INR for the extended date. Banks charge an extension margin to the original rate negotiated. In case, an exporter, (who has entered into a contract to sell USD forward) cannot abide by the contract, he has to buy the foreign currency from the spot market and delivers it to the bank on the maturity date. Both exporter and bank enter into another fresh forward contract for the extended maturity period.

Forward contracts can also be cancelled. If the importer/exporter can not use the forward contract, the contract can be cancelled by settling the difference in exchange between the forward contract rate and current day’s spot rate.

However, these flexibilities in forward contracts (closing early, extension and cancellation) may vary form bank to bank and from client to client in a bank. These options are exceptions rather than norms.

Normally, parties in a foreign currency forward contract cannot unwind their position. On the contract maturity date, one party gains at the cost of other. For example, suppose an Indian exporter expecting to receive USD1 mn after a year, enters into 1-yaer forward contract at INR 46.75 with XYZ bank. The exporter is expecting that without the contract he may have to sell USD at rate lesser than INR 46.75.

Suppose on trade date, the Indian exporter agrees to sell USD 1000 and receive INR 46750. On the maturity date, the Indian exporter delivers 1000 and receives INR 46750.

Forward contracts are zero-sum game. Figure 9(d) and Figure 9(e) explains the zero sum game. These two figures should be mirror image of each other. An exporter and a bank enter into the forward contract where the exporter agrees to buy INR (of course sale USD) at a price of INR 46.75. The exporter has taken a long forward position and the bank has takes the short forward position. On the expiry date, if the spot rate is greater than INR 46.75, the exporter looses and the bank gains. If the spot rate were higher than INR 46.75, then the exporter would have been better off without the contract. Similarly, on the expiry date, if the spot rate would be lesser than INR 46.75, the exporter gains. With a forward contract, the exporter is benefiting compared to an unhedged position.

In a similar token, an Indian importer benefits if INR depreciates after the forward contract rate has been decided.

The following Economic Times article, given in Box 9.2 explains the difficulties faced by Indian exporters who had entered into the forward contract, but ended up incurring significant loss as their expectation regarding future exchange rate was quite off the mark!.

Box 9.2. Leading exporters unwinding forward contracts

The Economic Times, 23^rd July 2008.

http://economictimes.indiatimes.com/articleshow/msid-3266587,prtpage-1.cms

A 10% dip in the value of the rupee against the dollar in three months should have resulted in windfall profits for exporters. But for many, there have been no gains. Forward contracts to sell the rupee at a fixed rate is leaving little opportunity for exporters to make money even though the exchange rate has swung the other way, with the rupee weakening.

In 2007, hit by a 13% rise in the value of the rupee, many exporters entered into forward contracts even for long-term receivables, as in for payments expected over two-three years. However, these contracts are now tying corporates to unprofitable exchange rates.

Now, the latest trend is for exporters in IT and pharma sectors to unwind these forward agreements and to go in for currency options instead.

Unlike forward contracts, which tie exporters to a preset deal, the options function as insurance cover. Companies need to exercise their option to sell dollars in the future only if the deal rate is favourable compared with the prevailing market rate. These are somewhat similar to employee stock options, which allow employees to buy equity shares at a fixed price. But unlike stock options, companies have to pay a premium to acquire a currency option.

Says TCS chief financial officer S Mahalingam, “Entering into a forward contract limits the company’s ability to protect its revenues. Such contracts are good only for a short period, say a quarter or two, wherein the company has a fair idea of how much its expenses would be.”

Leading technology companies have already begun switching over to options, moving away from forwards. Says Patni Computer Systems chief financial officer Surjeet Singh,

“Over the past two- three quarters, we have witnessed a shift in our hedging structure. Majority of our hedges now are in the form of option instruments. This is a good strategy in times of high exchange rate volatility.”

5.4: Non delivery Forward Contract:

A special type of forward contract is known as Non-Deliverable Forward (NDF) contract. NDFs are cash-settled and the settlement is done by calculating the difference between agreed upon forward rate and spot rate on the settlement date for an agreed upon notional amount of funds.

In an NDF, the principal amount, the forward exchange rate, fixing date etc. are agreed by both parties on the trade execution date. For example, an importer and a bank enter into an agreement where the importer would buy USD 1mn, six months from today by paying a negotiated rate of INR48.35/USD. USD1 mn is the notional principal amount. Suppose the fixing date is 1 week before the maturity date of six months. On the fixing date i.e, one week before the maturity date, the prevailing spot exchange rate is compared with the agreed forward exchange rate. These two rates will govern the NDF settlement on the maturity date. Suppose the spot rate on the fixing date is INR 47.75/USD.Both payment and receipt are netted off and on the maturity date, the importer pays INR 600,000 to the bank. In effect, the importer bought USD1 mn at an INR 48.35/USD and selling back to the bank USD 1 mn of INR 47.75/USD. Hence the importer pays INR 600,000 (the netted off amount). If, on fixing date, the exchange rate would have been INR 49.20/USD, the bank would pay the netted amount to the importer.

In an NDF, no exchange of foreign currency takes place.

In the above example, though USD leg of the contract is “not delivered” but actually, the amount settled is always in a “convertible currency” like USD. As most of the trading in NDF happens in offshore centers, settlement amount is always in the convertible currency.

Details given in Box 9.3, highlights the impact of NDF contracts traded outside India and its impact on INR/USD exchange rate.

Box 9.3.Rupee hit by an invisible force.

DNA MONEY 16th June 2008.

http://sify.com/finance/fullstory.php?id=14759072

An invisible force is stalking the dollar/rupee market and the Reserve Bank of India could do little to stanch the local currency's fast plunge. Blame the "illegal" overseas non-deliverable forward (NDF) market. Illegal, because such trades are not sanctioned by the Reserve Bank of India.

A NDF, as the name suggests, is a non-deliverable forward contract, in which banks buy forward dollars (book dollars today for delivery at a specified future date) in the local market for their clients and, simultaneously, sell equivalent dollars abroad, or vice-versa, so that on the delivery date they make a profit or loss, which is the difference between both the rates.

Globally, such deals are done in currencies that are not fully convertible to take advantage of –- or "arbitrage" –– the difference in the domestic forward rate and the NDF rate.

Contracts can range from one week to a year and Indian deals are mostly done in markets such as Hong Kong, Singapore and London (because their time zones match with the dealing room time here).

For example, the one-year forward rate in the domestic market is INR46.70/$ 1 (46.05 is the rupee rate plus a 65 paise forward premium), but in Hong Kong, the same forward is quoting at INR 47.68/$1 –- a clear arbitrage of 98 paise.

The RBI can't do anything to stop the trades since they are executed outside its jurisdiction, on foreign shores.

"It's illegal so we can't even talk about it. But it's a peculiar situation because the rupee is not fully convertible here, but countries where these trades are settled have fully convertible currencies. Also, the RBI can't just go ahead and legalise these trades because it would mean that they are jumping the regulation just because there are some players using this route," said a senior official of the Foreign Exchange Dealers Association of India.

Forex watchers said such deals have primarily pulled the rupee down to 46.05 from 42.65 a month back, a fall of nearly 8%.Dipti Deodhar, manager risk advisory, at forex consultant Mecklai & Mecklai, said hedge funds and foreign investors have made merry.

"NDF arbitrage has without doubt played a crucial part in the rupee weakness. Indian diamond companies with offices in markets like Hong Kong are also trading in NDF. Foreign institutional investors pulling out of India have also used this route to hedge bets," she said.

9.5: Forex futures contract:

A exchange traded forward contract is known as futures contract. Forward contracts are tailor made depending on the requirement of the contract buyers or sellers. However being exchange traded, futures contracts are standardized – contract size, maturity period etc. Being exchange traded, futures contract can be squared off easily which may not be possible in case of forward contract. In case of futures contract, the clearing house associated with exchange takes the counterparty risk – risk that the loss making party does not deliver during the maturity period. Traders also have to pay margins – initial and daily margin as exchanges require all traders to pay margin.

In India, forex futures contracts on INR/US$, INR/Euro, INR/Pound Sterling and INR/Japanese Yen are traded at some Indian exchanges like National Stock Exchange and United Stock Exchange. Annexure 9.1 shows the contracts specifications for the INR/USD trading at National Stock Exchange. Different aspects of the futures contract are given in Section 9.5.1.

9.5.1: Understanding forex futures contract specification:

Unit of trading of USD 1000 indicates that whenever a trader is taking position in 1 futures contract, the trader is taking position to buy/sell 1000 USD. For example, if a trader is taking 1 long futures contract at say INR 45.25 per USD, it indicates that the trader has agreed to buy 1000 USD and pay INR 45,250 in future. Tick size of INR0.25 indicates that, price quotations can very in multiple of INR 0.25. In other words, a trader can quote a price of INR45.25/INR 45. 50/INR45.75 etc. but the trader can not quote INR 45.23. Contract cycle of 12 months indicate that a trader can take position maximum upto 12 months. For example, in the month of August 2011, a trader can enter into a contract to buy/sell futures for August 2011, September 2011 upto July 2012. In other words, at a given point of time, 12 monthly contracts are available. Base price indicates the theoretical price based on spot rate and interest rate prevailing in both countries (explained later). Price operating range indicates the maximum price variation which can happen on a given day – akin to circuit filter in stock trading. Position limit indicates the maximum open position a trader can take depending on whether a trader is a retail client or a trading member or a bank. Minimum initial margin is the amount a trader pays the moment he/she takes a futures position. The open position is also marked-to-market (M-T-M) on daily basis. Based on M-T-M loss the trader pays additional margin – known as extreme loss margin.

M-T-M margin works like this: Suppose on day T, a trader takes a long futures position to buy 1000 USD at INR 43.50. The contract is going to mature after 3 months. On day T+1 day, suppose Indian rupee has appreciated and is quoting at INR 43.15. This indicates that the trader is buying 1 USD by paying INR 43.50 whose value is INR 43.15 today. Hence the trader is making loss. The trader has to pay M-T-M margin based on the loss. If the spot exchange rate would have been appreciated, then the trader would not have to pay the margin but the counterparty to the trader (short futures position holder) would pay the margin. To summarize, on Day T, the trader pays, the initial margin. Everyday the open positions are M-T-M and daily margin is calculated. Everyday the open positions are also settled based on the settlement price. Settlement price on the expiry date is different than the settlement price on the contract maturity date. On any non-expiry day, the settlement price is calculated as last half an hour weighted average price. On the expiry date, the settlement price is given by RBI –known as RBI reference rate.

Theoretical price or base price is calculated by taking into consideration the spot price and interest rates associated with a currency pair.

Where r_India and r_US indicates the interest rate in India and Us respectively. T indicates the maturity period of the contract. For example spot rate on Day T is INR43.50/USD. Suppose the contract is for 4 months. Interest rate in India is 8% per annum while in USA is 5% per annum.

	(1 + .08 *			4	)
			12
Forware Rate(F	) = INR 43.50 *					= INR 43.92/USD
INR /USD	(1 + .05 *			4	)
			12

As the interest rate in India is higher than the interest rate in USA, Indian rupee is expected to depreciate in future. Hence on Day T, theoretical price is INR 43.92/USD.

  

The electronic order book for “USDINR 290709” is given in Table 9.2 taken from National stock Exchange website. “Best bid” and “best ask” prices are quotations respectively from the buyers and sellers side. Order matching happens when best buy order matches with the best ask price.

The electronic order book for “USDINR 290709” is given in Table 9.2 taken from National stock Exchange website. “Best bid” and “best ask” prices are quotations respectively from the buyers and sellers side. Order matching happens when best buy order matches with the best ask price.

Table 9.2 : Snapshot of the electronic order book for “USDINR 290709” Source http://www.nseindia.com

All most all major exchanges offer foreign currency futures for different currency pairs. For example, at the CME, futures on around 40 different currency pairs available for trading. http://www.cmegroup.com/trading/fx/ lists the currency pairs, duration of futures contract, trading and settlement details. The exchange website mentions the following details regarding futures and options on currency pairs: “CME Group offers the largest regulated foreign exchange marketplace in the world, and the second largest electronic FX market. We provide trading of 49 futures contracts and 32 options contracts based on 20 global currencies, including major world currencies and currencies of emerging markets.”