X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
The Colour of Money - III - Outside View by Vikram Murarka
 
 
The Colour of Money - III

Speaking to a number of exporters, importers, CFOs over the last several years, we have felt that most people find forex to be a tough beast to tame and view it with fear. Granted, managing forex risk is not easy, but it is not impossible either. To start with, there is a need to throw light on some fundamental concepts of forex risk management. In this series of articles, we will deal with questions such as:

  • What is your actual risk?
  • How much should you hedge?
  • What is Early Delivery?
  • Is the Forward Rate a forecast?
  • How to choose a Benchmark?
How about Early Delivery?

Many clients we work with, especially SME clients, and more especially Exporters, tend to prefer an "Option Period" Forward Contract rather than a "Fixed Date" Forward Contract.

OPTION PERIOD DELIVERY
The "Option Period" Forward Contract is an exotic animal, most likely found only in the Indian forex market. Why do Exporters like this strange hedging instrument so much? What "perceived" benefit does it give them? How does it work? And why is it actually a sub-optimal instrument?

Many exporters do not enjoy the luxury of exporting on the basis of strict L/C terms. As such, many a times they do not know the exact date on which their receivable will materialise. At best they have a rough idea of the time period in which they can expect their customer to send the payment. Hence, when they want to undertake a Forward (Sale) Contract against their receivable, they are unable to give a specific value date for the forward contract to their bank. This is a common problem.

So, the banks have come up with what looks like an attractive, accommodative and customer friendly solution, which is often more profitable for the bank than for the customer. In a magnanimous gesture, the bank "allows" the exporter to deliver the Dollars within a specified period (often a calendar month) instead of on a specific date. For example, on 23rd April, an Exporter who is expecting to receive payment by end of June is allowed to enter into a Forward Contract to sell Dollars to the bank any day between 1st and 30th June. For this, the exporter is entitled to get the Forward Premium for the period 26-April to 31-May, or for little more than 1 month. Note here that the forward period will be counted from 26-April onward since 25-April is the Spot date for 23-April.

The bank, on the other hand, can go out into the market and sells Dollars forward for value date 30-June, instead of value date 31-May! In other words, it sells 2 months 5 days forward gets premium for 66 days (26-Apr to 30-Jun) instead of for 36 days (26-Apr to 31-May).

EARLY DELIVERY
What happens in case the payment comes in earlier than 30-Jun, say on 15-Jun? Under the Option Period Forward Contract, the exporter simply delivers the Dollars to the bank and is credited with the Forward Rate, as previously agreed, that was then applicable on 23-April, for 31-May. He is unaware of the fact that he has foregone premium for 15 days. What does the bank do, on the other hand? The bank, which had previously "received" premium for the entire period from 26-April to 30-June from the market, "pays" premium for the period 16-June to 30-June, back to the market. On a net basis, therefore, the exporter receives premium for 36 days months whereas the bank receives premium for 51 days.

This is pure profit for the bank, which could as well have been to the account of the Exporter if he had done the same thing as the bank, viz. (1) Sold Forward for fixed date 30-June (2) Given Early Delivery on 15-June and (3) Paid back premium for the period 16-June to 30-June through a swap transaction.



An Early Delivery is a perfectly correct and legitimate transaction, well within the Reserve Bank Of India's (RBI) guidelines, and has been around for at least two decades, quite possibly longer. Many Exporters do not avail this facility because they are either not aware of this facility or they do not want to take on any additional administrative work.

BAD FOR IMPORTERS ALSO
The Option Forward Contract is bad for the Importer as well. Say on 23rd April, an Importer asks for an option forward contract for the period 01 to 30-June, he is asked to pay premium for the full 66 days from 26-April to 30-June. Instead, he could have asked for a fixed date forward contract for value date 30-June. Then, if has to "take" early delivery of the Dollars from the bank on 15-June, he can ask to be refunded the then prevailing forward premium for 15 days, from 16-

June to 30-June. In this manner he ends up paying premium for only 51 days, instead of for 66 days.

NEED TO WAKE UP
Both Exporters and Importers need to wake up and look at the amount of money they are losing by taking option period forward contracts and not hedging for a fixed date. The average monthly premium over the last couple of years has been 20-30 paise. We can safely assume that roughly half of this is foregone when an Exporter asks a bank for a option period forward contract instead of giving "early delivery" on a fixed date forward contract.

10 paise foregone on every $ 1 million sold every month translates into foregone revenues of Rs 12,00,000/- every year. Is that worth losing? Or is it worth capturing? You decide.


This article has been authored by Vikram Murarka. He is the Founder of and Chief Currency Strategist at Kshitij Consultancy Services, India's first forex website, started back in 1998. Vikram has been forecasting and trading currencies since 1991.

The Colour of Money - Previous article | Next article

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

 

Equitymaster requests your view! Post a comment on "The Colour of Money - III". Click here!

  
 

More Views on News

Sorry! There are no related views on news for this company/sector.

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS