Forward Market Exchange Rate – Concept & Hedging Use

Business hates uncertainty. If I have to pay $1 Million in 3 months, and the rate creates a loss, I am in trouble. The Forward Market fixes this.

1. What is a Forward Contract?

It is an agreement between a Bank and a Customer to buy/sell currency at a fixed rate on a fixed future date.

• Purpose: Hedging (Protection against risk).
• Obligation: You must buy/sell on that date. You cannot back out.

2. Premium and Discount

Forward rates are rarely the same as Spot rates.

• Forward Premium: Changing more for future delivery.
  • Forward Rate > Spot Rate.
  • Example: Spot = 80, 3-Month Forward = 81. Dollar is at a premium.
• Forward Discount: Charging less for future delivery.
  • Forward Rate < Spot Rate.
  • Example: Spot = 80, 3-Month Forward = 79. Dollar is at a discount.

Calculation Formula: Premium % (p.a.) = [(Forward - Spot) / Spot] * [12 / Months] * 100

3. Hedging Example (Importer)

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4. Exam Notes: Writing the Answer

Question: "Explain Forward Exchange Contract and how it is used for Hedging." (5 Marks)

Answering Strategy:

1. Define: "Agreement for future delivery at fixed price."
2. Usage: Explain with Importer example (fearing depreciation) or Exporter example (fearing appreciation).
3. Formula: Write the Premium formula for extra marks.

Summary

• Fixed: Forward rate creates certainty.
• Cost: The difference between Forward and Spot is the cost of hedging.
• OTC: Forward contracts are Over-The-Counter (customized between Bank and Client), unlike Futures.

Quiz Time! 🎯

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