How does forward contract work ?

Forward contract is a derivative contract between two parties for buy and sell. Here we will understand forward contracts for foreign currency transactions. Forward Contracts helps to cover risk in underlying business transactions in foreign currency. If you are a student, CA , founders or any other finance professional, this is a useful post for you. We will try to decode the forward contract in a practical way based on my treasury experience . You will get a better idea , How does forward contract work ?

Example – How does forward contract work ?

Say you are heading treasury for a corporate and your company is importing steel worth USD 1 million from an overseas supplier . You have a 30 days payment term with supplier from date of bill of lading . The bill of lading is of 01st Jan and you have to pay USD 1 Million to your supplier on 30th Jan . You are working in India and the company is incorporated in India . Your domestic currency is INR and foreign currency is USD . Foreign currency rates are fluctuating every day based on various factors . So if the currency rate is INR 82 per 1 USD on 1st Jan, it can be 82.50 on 30th Jan or it can be 81.50 . We don’t know . How to cover risk in underlying purchase transactions against foreign currency risk ?.

Answer is a Forward contract . Forward contact is a plain vanilla product . You can approach your bank for entering a forward contract. 

Step by Step Guide – How does forward contract work ?

1. You should have an Fx limit with your bank to enter a forward contract 
2. I assume you have an Fx limit with your bank so you have to call the dealing room of the bank to buy a forward contract for USD 1 Million
3. There are two types of currency rates available i.e Bid and Ask . Bid means you have to pay INR and buy USD to pay to supplier i.e. it is applicable for Import. Ask means what you can get by selling dollars and getting INR. This is applicable in case of export when your foreign customer pays you in USD and you have to convert it in INR. You will always find differences in Bid and Ask rate for a currency . When you want to sell dollars , you will get less rate in ask as compared to Bid .
4. So you have to approach the dealing room of your bank to buy USD. Just wait ! By getting a phone number for the dealing room , you cannot get a rate and enter into a deal. You should be authorised to enter a transaction on behalf of your company so you need a Board Resolution/Authority letter from your company. 
5. This Board resolution should be submitted to the bank in advance and once your name is registered in their system, you can enter a forward contract with the bank .
6. Now you need a performa or final invoice from the supplier before entering a forward contract. 
7. Based on this invoice you have to ask your banker to provide a forward rate on 30th Jan i.e. due date of payment of your invoice. 
8. Bank will share quote , say it is 12 paise i.e. Spot + Premium = Forward rate. Say Spot is 82 so your forward rate will be 82.12 
9. Spot rate is T+2 day rate. i.e. today’s rate is cash . Tomorrow’s rate is Tom and rate for day after tomorrow is Spot and rate after 30 days is forward .
10. If you are fine with the rate , you have to confirm the rate to the banker on a recorded line and they confirm the deal. Banks buy similar dollars from dealers i.e. inter bank transactions .
11. Now you have covered foreign currency exposure under purchase contract by 82.12 and you don’t have to worry about currency fluctuation . It can go anywhere above 83 also you don’t have to worry .
12. The Bank will earn a premium and charges on this transaction. They will share a forward contract with you. Authorised signatory should sign agreement and share with bank.
13. Nowadays, banks are providing online portals for accepting forward contact. 
14. On the due date of payment i.e. 30th Jan, you have to keep balance in your account and advise the bank to pay to the supplier using the forward contract which you have entered earlier . You have to provide a covering letter with invoice and supporting documents to the bank .
15. The Bank will get delivery of dollars as per contracts and pay to the supplier. Your bank account will be debited with agreed forward rate i.e. USD 1 Million multiplied by INR 82.12/USD ,Rs.8.21 crores .

Why should you enter into a forward contract ?

This depends on the Treasury and Risk Management policy of the organisation . Few organisations want to keep their exposure open and want to settle accounts on the day when a transaction is being settled. However in few organisations , you will find a strict treasury policy i.e to cover your exposure within 3 days from the date it crystallised . It is recommended to have a forward contract because the company is not dealing in USD but in steel so it is better to cover risk in foreign currency .

You can get foreign exchange rate from FBIL website .

Hope you get an idea about , How does forward contract work ? Please give your valuable feedback in the comment section .

You can read our post Practical aspects of Letter of credit to get an idea of Letter of credit.