Example:
In order to hedge the risk of not getting enough manganese, you go into a forward contract with a manganese company. The manganese company agrees to supply you a specified amount of steel of a specified quality at a certain date 6 months down the line at your plant. The price is also negotiated at this point of time. This is the price that you will pay when manganese is delivered. This is a forward contract.
Use of Forward Contract:
Example:
Now suppose in 90 days, when you receive $1 million, the exchange rate is Rs 42 for a dollar. Essentially, you get $1 million but when you convert, you get only Rs 42 million. There could be a case when dollar might appreciate further and you may get an exchange rate of Rs 48 for a dollar. In this case, the company is getting more. However, this is just speculation and businesses usually hedge the risk instead of relying on speculation.
To hedge this currency risk, what you can do is to enter into a forward contract with your bank to exchange dollar with a pre-determined rate of conversion (say 1 USD = Rs 44.13). This will ensure you at least Rs 44.13 million when the client pays irrespective of the currency exchange rate at the end of 90 days. How do you decide the number 44.13?
Deciding forward exchange rate
Let’s make an assumption:
Timeline | Value of USD | Value on Indian Rs |
Current (Spot) | 1 | 45 |
In 90 days | 1*(1+0.04) = 1.04 | 45*(1+0.02) = 45.90 |
They both should be equal after 90 days. This means $1.04 = Rs 45.90. This implies $1 will be Rs 44.13. This is the theoretical value for the forward contract and gives good approximation of what should be the 90 days forward exchange rate of USD and Indian Rs.
Forward Contract on Equity:
Suppose you have a stock and someone wants to buy it after a year. The current market price of the stock is Rs 200. At what price you should promise to sell your stock to him after a year.
The method to calculate forward price is simple.
Forward price = Spot price or current price + cost to carry
Cost to carry = Funding cost – dividend
Let’s do it with an example. Let’s assume you do not have a stock. Someone comes to you and wants to buy stock X whose current market price is Rs 200, after a year. Assume that the stock pays a dividend of Rs 5 after a year.
What you can do is to borrow Rs 200 at interest rate (say 10%) from the bank and buy the stock at current market price. At the end of 1 year, you received a dividend of Rs 5. Now you have to sell the stock to the person with whom who signed the forward contract.
Let’s look at the liabilities you have at the end of 1 year. You have to pay the bank Rs 200 and the interest on Rs 200 at the rate of 10%, in total Rs 220. At the same time, you got Rs 5 as dividend. You can use this money to pay the bank. The extra you will need is Rs 220 – Rs 5 = Rs 215.
Now, if you have already have the stock and want to enter into the contract, you should set the forward price at Rs 215 or more, ignoring transaction costs.
Forward contract on Interest Rate
This is very popular in institutional and business borrowers. The forward interest rate helps borrowers hedge the interest rate exposure. Let’s take an example here.
Your company has borrowed 1 crore from ICICI Bank at the floating rate at MIBOR + 0.5%. MIBOR is Mumbai Interbank Offer Rate. Most of the borrowings happen over this rate. This rate is set at specific intervals. Let’s assume that current MIBOR rate is 8% and it changes every 3 months. This means that you are exposed to the interest risk because MIBOR may go up from 8% now to 12% in a year’s time.How do you hedge yourself against the interest rate risk?
This is where forward rate agreement comes into picture. Your company approaches a forward rate dealer and goes into an agreement with a notional value of 1 crore that if the MIBOR goes beyond 8% in any period in future, the dealer will compensate you for the extra interest beyond 8% MIBOR. Similarly, if the MIBOR rate is below 8%, you will have to compensate the dealer. The use of notional value is in calculating the payment owed by the dealer to you for vice versa.
Let’s take an example:
Say, in 3rd quarter, the MIBOR is reset at 9%. If your company doesn’t buy the forward rate agreement, it will have to pay the interest rate at 9.5% for that period. However, if you have bought forward rate agreement, the dealer will pay the extra interest of 1% (i.e. 9% – 8%). Your burden will simply be 9.5% – 1% = 8.5%.
Take other scenario. The MIBOR is reset at 7%. In this case, you have to pay the bank at MIBOR + 0.5% = 7.5%. At the same time, you will have to pay the dealer the difference of 8% and the reset MIBOR, i.e. 8% – 7% = 1%. Your effective rate is 7.5% to the bank and 1% to the dealer, equalling 8.5%.
This means that your effective interest rate is 8.5% throughout the period irrespective to MIBOR as long as forward rate agreement (FRA) is active.
Conclusion
Forwards, as mentioned earlier, is usually not used by retail investors. However, this is a great hedging tool for businesses and institutional borrowers. There is the reason why it is not popular in retail investors and that it is delivery based. Take for example, a retail investor bought soya forwards. Once the delivery date approaches, the retail investor has to take delivery of tons of soya. What will the retail investor do with that? Futures solve this problem. In case of futures, the retail investors sell the contract itself in the open market and avoid the delivery. In fact stock exchanges facilitate standardized contract to discourage delivery. You will read more about futures in next few articles.
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Pankaj Priyadarshi
Pankaj Priyadarshi is an author at Lastbull.com. He has 11 years of international and domestic experience in the areas of Finance, Management, and Business Analysis in the USA and India.He is a co-founder of 'Vertical Grass', a consulting initiative in the area of finance. A Graduate from IIT(Engineering) and ISB(Management).
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