Covering Exchange Risk on forward Market

Covering Exchange Risk on forward Market

Often, the enterprises that are exporting or importing take recourse to covering their operations in the Forward market. If an importer anticipates eventual appreciation of the currency in which imports are denominated, he can buy the foreign currency immediately and hold it up to the date of maturity. This means he has to block his rupee cash right away. Alterna­tively, the importer can buy the foreign currency forward at a rate known and fixed today. This will do away with the prob­lem of blocking of funds/cash initially. In other words, Forward purchase of the currency eliminates the exchange risk of the importer as the debt in foreign currency is covered.

Likewise, an exporter can eliminate the risk of currency fluc­tuation by selling his receivables forward.

Example

            From the data given below calculate forward premium or discount, as the case may be, of the £ in relation to the rupee.

Spot	1 month forward	3 months forward	6 months forward
Re/£	Rs 77.9542/78.1255	Rs 78.2111/4000	Rs 78.8550/9650

Solution

Since 1 month forward rate and 6 months forward rate are higher than the spot rate, the British £ is at premium in these two periods, the premium amount is determined separately both for bid price and ask price. It may be recapitulated that the first quote is the bid price and the second quote (after the slash) is the ask/offer/sell price. It is the normal way of quotation in foreign exchange markets.

Premium with respect to bid price

                           1 month = Rs78.2111 -Rs 77.9542 x 12 x 100 = 3.95% P.a                                                                  Rs 77.9542              1   

                                 

                                              

                          6 months = Rs 78.8550 -Rs 77.9542 x 12 x 100 = 2.31% P.a                                                                  Rs 77.9542              6

 

Premium with respect to ask price

                           1 month =    Rs 78.4000 -Rs 78.1255 x 12 x 100 = 4.21% P.a                                                            Rs 78.1255                    1

                        6 months =   Rs78.9650-Rs 78.1255     x12 x 100 = 2.15% P.a                                                                                                Rs 78.1255                     6

In the case of 3 months forward, spot rates are higher than the forward rates, signalling that forward rates are at a discount.

Discount with respect to bid price

                                    

                          3 months =  Rs 77.9542 -Rs 77.6055    x 12 x 100 = 1.79% P.a                                                        Rs 77.9542                        3

Discount with respect to ask price

                           3 months= Rs 78.1255-Rs 77.7555 x 12 x 100 = 1.89% P.a                                                                    Rs 78.1255             3