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Module - 9 Foreign Exchange Contracts: Spot and Forward Contracts

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Module - 9 Foreign Exchange Contracts: Spot and Forward Contracts NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. Module - 9 Foreign Exchange Contracts: Spot and Forward Contracts Developed by: Dr. Prabina Rajib Associate Professor (Finance & Accounts) Vinod Gupta School of Management IIT Kharagpur, 721 302 Email: [email protected] Joint Initiative IITs and IISc – Funded by MHRD - 1 - NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. Lesson - 9 Foreign Exchange Contracts: Spot and Forward Contracts Highlight & Motivation: Forex market players can trade foreign exchange in differing maturities and using different types of instruments i.e, cash, tom, spot, forward, futures, swaps and options market. In this session, different aspects spot, forward and futures contracts are discussed. The difference between forward contract and futures contracts is also part of this session. Different dimensions of contract specification of futures contract traded at National stock exchange have also been elaborated. Hence the objective of this module is to understand: • Cash, Tom, Spot trading o Trade date, settlement date o Spot trading rollover mechanism. • Foreign Exchange Forward contracts o Fixed maturity contract o Partially optional contract o Fully optional contract o Non-delivery forward contracts. • Foreign Exchange Futures Contract o Different dimensions of foreign exchange future contract specification trading at National Stock Exchange of India. Joint Initiative IITs and IISc – Funded by MHRD - 2 - NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. 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. In the next section, Section 9.2 the spot transactions details are elaborated. 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. Joint Initiative IITs and IISc – Funded by MHRD - 3 - NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. 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. Joint Initiative IITs and IISc – Funded by MHRD - 4 - NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. 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 Joint Initiative IITs and IISc – Funded by MHRD - 5 - NPTEL International Finance Vinod Gupta School of Management, IIT.Kharagpur. 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).
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