Early delivery and Cancellation of Forward Contract

What is a Forward Contract?

This is the simplest form of derivative that can be designed/customized as per the requirements of end-users. Since it is a derivative there is an underlying asset from which value of this contract is derived. It obliges one party to buy and the other party to sell, a specified quantity of a nominated underlying financial instrument at a specific price on a specified date in the future.  Forwards are not standardized. The term in relation in relation to contract size, delivery grade, location, delivery date and credit period are always negotiated.

The buyer delivery its value on maturity either by delivery of by cash settlement.

The forward rates can be at premium or Discount.

Example: we have current spot exchange rate of 1USD=INR100, and 6 months forward is 1USD=INR110, This means Dollar is Costlier than INR. Dollar is at a premium of INR 5. and similarly INR is at discount. 

Forward Premium and Discounts are usually expressed as an annual percentage of the difference between Spot and the forward rates. and Premiums and discounts may not be necessarily equal for the same pair of currency. i.e In the above example the premium and discount is not equal when calculated on Percentage term.

Why Forward Contract is entered into?

Suppose S an exporter has sold certain goods to a foreign state and expects the home currency to be weaker in the future date and there is another party say a bank "B" who expects the home currency to be stronger, so In order to safeguard itself exporter enters into a forward arrangement with the buyer of such contract i.e bank here. Here on the specified date in future banker will credit the account of the exporter held by him with an amount equivalent to the agreed-upon rate and that foreign currency(underlying asset is taken over by the bank). Moreover, when the bank enters into such a transaction it will cover itself in the market.

The fate of the Forward Contract?

Whenever any forward contract s entered into it meets any of the following three fates:

1. Delivery under the Contract
1. Delivery on Due date
• This situation does not pose any problem as the rate applied to the transaction will be the rate originally agreed upon.
2. Early delivery
When a customer of the bank requests early delivery of a forward contract, i.e., delivery before its due date, it is known as early delivery. The charges for early delivery will comprise of: (i) Swap difference (irrespective of whether an actual swap is made or not); (ii) Interest on the outlay of funds (not below the prime lending rate of the respective bank on the outlay of funds); and (iii) Flat charge of (or handling charge) Rs. 100 (minimum per request) as per FEDAI rules (In case of India).
3. Late delivery
2. Cancellation of the contract
1. Cancellation on due date
2. early cancellation
3. late cancellation
3. Extension of the contract
1. Extension on the due date
2. early extension
3. late extension

Certain terms which need to be understood in case of early delivery:

Example: Forward purchase contract has been booked by an exporter for USD 10000 @ 66.85 delivery 3rd month. However, the documents are delivered in the first month. (This means exporter has entered into a forward contract arrangement with the bank to deliver USD10000@66.85 after 3 months, however exporter requests bank to accept delivery of such underlying asset i.e currency i.e USD here in the first month). The following are the market rates.

Spot Rate on date of contract 66.30/66.45(Bid/ask rate or Buy/Sell rate)

Spot rate (on the date of delivery) 1st month- Rs. 66.40/ 66.50

Forward Rate 2 months (on the date of delivery)- Rs. 66.70/ 66.80

Solution:

In the above example, the early delivery has compelled the Bank to effect the following transactions:

1. Spot sale of USD 10000/ after 1st month @ Rs.66.40= 6, 64000/- (i,e Bank has in one months time received USD , He has to sell that currency in the market at the prevailing spot rate
2. Forward purchase 2 months @ Rs.66.80 for USD 10000= 6, 68000/- (to coincide with the original maturity period or we can say, since the bank has initially entered into USD forward purchase contract it has covered itself by taking another 3 months forward contract to sell the USD in the market) 

(There is a Sale and Purchase of contracts as illustrated above, the difference is the swap difference as enumerated below)

Calculation of Swap difference: The difference between Transaction nos. 1 and 2 is the swap difference In the swap above, the Bank has to sell the foreign exchange received at Rs.66.40 to the market and purchase the same amount two months forward at Rs. 66.80 from the market (Since the customer will not be in a position to deliver the foreign exchange as contracted in the third month, the Bank has to honour its sale transaction commitment and hence a forward purchase for 2 months to coincide with the original maturity period @ 66.80 ) and hence the swap loss is 40 paise per USD which amounts to Rs.4000/- for USD 10000/- . This loss of Rs.4000/-is to be recovered from the customer. This simply also means there is a swap of contracts earlier, had there been no early delivery the new forward contract for two months would not have been required and there would have been no swap difference and that would be the case of delivery on the due date.

Calculation of Interest on outflow/outlay of funds:

In the above example, Customer was paid at contracted rate @ Rs.66.85 for USD10000/- is Rs.668500.00 as per original contract( what was originally contracted is to be paid after deducting swap diff, interest, fixed charges since bank has accepted early delivery). The bank has an immediate outflow of funds, as Rs.668500.00 is paid to the Customer. The inflow of funds from the spot sale is only Rs.664000.00. Hence, there is an outlay of funds (Rs.668500.00 – Rs.664000.00) of Rs.4500/-. (Difference between the amounts paid and amount received).Here; interest on difference of Rs.4500 shall be recovered from the customer at a commercial rate of interest from the date of delivery to the date of maturity of original forward contract. (i.e. interest for 2 months at a commercial rate fixed by the bank). (This is because had there been no early delivery the bank had earned interest on 4500 for two months)

Note: Cash outlay arises when the swap spot selling rate is lower than the contract rate. If the foreign currency is at a discount in direct contrast to the above example, swap difference shall be paid to the customer.

In case of EARLY DELIVERY IN SALE CONTRACT we have to substitute spot purchase by spot sales and forward sale substituted by forward purchase (coincide with the original maturity period) in the above example for calculation of the swap difference. Here cash outlay arises when the swap spot buying is higher than the contract rate.