Exporter

Request for Forward Contract,

Value 1 year forward

Bank
A

Borrow
Bank
X

$ 0.95

Bank
A

Sel
l
$ 0.95
Rs
37.05
4
Receive Maturity
Proceeds

3
Deposit/Le
nd
Rs 37.05

Rs 39.25
Bank
Z

Bank
Y

Forward Exchange Rate

1 $ = Rs 39.20
1$
Bill
1
Borrow
$ 0.95

Bank
X
6

Repay $
1.00 Loan
+ Int
3
Lend/Deposi
t
Rs 37.05

Exporter
5

Rs 39.20 ( 39.25- 0.05)

2
Sell
$ 0.95

Bank
A

RS 37.05

Bank
Y

Bank
Z

Receive
maturity
Proceeds
incldg Int
Rs 39.25
Spot Exchange rate 1 $
=
Rs 39.00

3 Months later
Spot $/INR = Rs 35.00
(say)
After the Exporter booking a Forward Contract at 1$ = Rs 39.20
(value 1 year Fwd)
Foreign Buyer cancels the order placed with the Exporter

Exporter

Request to cancel
Forward Contract

Bank
A

Exporter

Bank
X

3
Prepay $
loan + Int =
$ 0.96 =(Rs
0.50 ) Break
deposit

Rs 2.99 ( Gain to Exporter

without making any
Exports ! )
Buy
2
Bank
$ 0.96
Bank
Y
A
1
Rs+ Int
( 37.59 )

Rs
33.60

Spot Exch
Rate
Bank
Spot:
Z
Exch Rate 1$=Rs
35.00
1$=
1
Rs.35.00
Gain on Cancellation of Fwd Contract: Rs 37.59Rs 33.60 = Rs 3.99
Less Interest on $ loan converted into Rs
= Rs 0.50
Less Bank As operating Expenses + margin
Rs 0.50
Amount payable to Exporter
Rs
2.99

3 Months later
Spot $/INR = Rs 45.00
(say)
After the Exporter booking a Forward
Contract at 1$ = Rs 39.20 (value 1 year
Fwd)
Foreign Buyer cancels the order placed with
the Exporter

Exporter

Request to cancel
Forward Contract

Bank
A

Exporter

Bank
X

3
Prepay $ loan
+ Int =
$ 0.96 =(Rs
0.50 )
Break
deposit

Rs 6.61 ( Loss to Exporter)

Bank
A
1
Rs+ Int
( 37.59 )

Buy
$ 0.96

Bank
Y

Rs
43.20

Spot Exch
Rate
Bank
Spot:
Z
Exch Rate 1$=Rs
45.00
1$=
1
Rs.35.00
Loss on Cancellation of Fwd Contract: Rs 37.59Rs 43.20 = Rs (5.61)
Add Interest on $ loan converted into Rs
= Rs
(0.50)
Add Bank As operating Expenses + margin
Rs
( 0.50)

IN SUMMARY
A Forward Contract booked by an Exporter seeks to protect his
profitability from his business operations (Export of T-Shirts in
the present examples)
As long as the Forward Contract is not cancelled, and the
contracted export takes place, the Exporter does not make any
gains/losses on account of the fluctuations in the foreign currency
versus INR (if exports invoiced in foreign currency
If a Forward Contract(Exports) is cancelled, there could be a
gain for the Exporter , if the foreign currency (vs INR) price
depreciates as on date of cancellation as compared to the spot
rate on date of booking the contract.
If a Forward Contract(Exports) is cancelled, there could a loss to
the Exporter ,
if the foreign currency (vs INR) price appreciates as on date of
cancellation as compared to the spot rate on date of booking the
contract.

MOVEMENTS OF USD/INR SPOT RATE DURING

THE PERIOD UNDER EXAMINATION

Periods when an Exporter could have GAINED on account of

Export Fwd Contract Cancellations :
Period
USD/INR
Depreciation of USD/INR
_____
From To
Exporters (Gross)

Max
Max Gains to

5.3.07 26.07.07

44.68

40.87

3.81

17.8.07 10.10.07

41.34

39.24

2.10

17.3.08 - 17.4.08

40.74

39.79

0.95
6.86

Periods when an Exporter could have LOST on account

of Export Fwd Contract Cancellations :
Period
USD/INR
Depreciation of USD/INR
_____
From To
Exporters (Gross)
24.7.07- 17.8.07
40.24 - 41.34
16.01.08- 17.3.08
17.4.08 - 27.5.08

39.29 40.74
39.78 42.99

Max
Max Loss to
1.10
1.45
3.21
5.76

Disadvantages of Forward Contracts

Locks an Exporter into a fixed rate of exchange

( 1 $ = Rs 39.00 say )

Exporter has to deliver the underlying whatever

may be the Exchange Rate on date of delivery .

Forward
Contract

USD/INR as on Fx P/L for

delivery date
unhedged
Exporter

1$ = Rs 39.00

1 $ = Rs 49.00

+ Rs 10.00

1 $ = Rs 29.00

- (Rs 10.00)

Fx P/L for
hedged
exporter1 4
Nil
Nil

3. Loss on cancellation , if spot USD/INRhigher than Rs 39.00 on

date of cancellation

Advantages in booking Forward Contracts

1. No upfront fees
2. Fx risk due to currency fluctuation
completely eliminated
3. Profit on cancellation if spot USD/INR
lower than Rs 39.00 on date of cancellation

Options
A better hedging tool
PUT OPTION : Gives the buyer (exporter) the
RIGHT but not the OBLIGATION to deliver (SELL)
the underlying (USD/INR) on a specified future
date at a specified exchange rate fixed now (1 $
= Rs39.00 say ) .
CALL OPTION : Gives the buyer (importer) the
RIGHT but not the OBLIGATION to take delivery
(BUY) underlying (USD/INR) at a specified
exchange rate fixed now (1 $ = Rs 39.00 say )

OPTION PREMIUM
The buyer of the option pays an upfront fee (premium) to
the seller of the Option

Advantage of Put Options over forward contracts for and

Exporter

Forward contract

Put option

Locks in forward rate (at

1$ = Rs39.00 say )

The exporter is under no

obligation to exercise
option and deliver
underlying at contracted
rate.

Unable to enjoy upside

( 1 $ = Rs 49.00 )

Will exercise Option

and deliver underlying if
rate is say 1 $ = Rs
35.00
Will not exercise
Option if rate is say 1 $
= Rs 49.00

Disadvantages of Options as compared to

Forward Contracts
Forward Contract

Put Option

No uprfront fees for booking

contract

>Upfront fees payable ,

depending on volatility of
USD/INR
Upside available only if
exchange rate exceeds
fee/premium for buying the
Option.
Example : Option Price 1 $ = Rs
39.00
Premium

= Rs

2.00
Upside available only if
USD/INR exceeds

- Rs

Why did Exporters prefer Zero Cost

Option Structures ?
Exporters had been booking Forward Contracts
for ages, and there was no fee for buying this
hedging product.
They did not want to pay the Option premium
which would cut into their business profits, as
cost of Option could not be loaded on to the
foreign buyer

Enter Zero cost Option Structures

Forward Contracts

Zero Cost Option Structure

>Down-side risk protected

>Down side protected with

Exporter buying a PUT Option

>Upside potential limited to the

rate at which forward contract

>Upside limited with Exporter

booked

writing/selling a CALL Option

> No Upfront Fees

>Cost of Put Option set-off by

premium received by selling a
CALL Option.
No net receipt or payment of
premium, hence no upfront fees

Enter Zero cost Option Structures

Forward Contracts

Zero Cost Option Structure

Cancellation , when spot is

lower than contracted rate, gives
profit.

Cancellation of structure, when

spot is lower may not necessarily
result in profit, as Exporter would
have to buy a matching CALL,
and the premium is a function of
volatility, and not a linear
function.
In the case of Exotic Zero Cost
structures , the Premium for
buying back the CALL, may be
much more than the favourable
movement of the spot.

Some arithmetic of Forwards and Zero

Cost Structures
Forward Contracts

Zero-Cost Structures

Exporter books 3 $ forward at 1 $

= Rs 39.00

Exporter buys a Zero Cost

Structure:
1 $ PUT @ 1 $ = Rs 39.00
2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1$ = Rs 49.00

On Due date : 1 $ = Rs 49.00

Exporter delivers $ 3 at Rs 39.00

Buyer of CALL excercises option

Fx P/L ( Rs 49.00 39.00 ) = Rs

at Rs 41.00

10.00

Exporter delivers 2 $ CALL @ 1 $

= Rs 41.00
Exporter does not exercise PUT,
and sells underlying 1 $ @ 1 $ =
Rs 49.00
Gain on PUT

( 49.00 39.00 ) =

Some arithmetic of Forwards and Zero

Cost Structures
Forward Contracts

Zero-Cost Structures

Exporter books 2 $ forward at 1 $

= Rs 39.00

Exporter buys a Zero Cost

Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1$ = Rs 49.00

On Due date : 1 $ = Rs 49.00

Exporter delivers $ 2 at Rs 39.00

Buyer of CALL excercises option

Fx P/L ( Rs 49.00 39.00 ) = (-)Rs

at Rs 41.00

10.00

Exporter delivers 2 $ CALL @ 1 $

Total Fx Loss ( 2 * 10 ) = (-) Rs

= Rs 41.00

20.00

Exporter does not exercise PUT

Loss on CALL
=

( 49.00- 41.00)

8.00

Total Loss ( 2*8) = (-) Rs 16

Some arithmetic of Forwards and Zero

Cost Structures
Forward Contracts

Zero-Cost Structures

Exporter books 2 $ forward at 1 $

= Rs 39.00

Exporter buys a Zero Cost

Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1 $ = Rs 29.00

On Due date : 1 $ = Rs 29.00

Exporter delivers $ 2 at Rs 39.00

Buyer of CALL does not excercise

Fx P/L ( Rs 39.00 29.00 ) = + Rs

option at Rs 41.00

10.00

Exporter sells 1 $ unhedged

Total Profit : ( 2 * 10.00) = + Rs

underlying @ 1 $ = Rs 29.00

20.00

Exporter exercises PUT, and

delivers underlying 1 $ @ 1 $ =
Rs 41.00
Gain on PUT (41.00-29.00) = Rs

Conclusions regarding choice between FC

and Zero Cost Option
Forward Contract

Zero Cost Option Structure

Most advantageous when :

Most Advantageous when :

Spot Lower than Contracted Rate

Spot Equal to the Forward

Contract Rate

Least Advantageous When :

Least Advantageous when :

Spot Higher than Contracted Rate

Spot higher than

Strike/Contracted Rate

From April 2007 to Oct 2008

From April 2007 to Oct 2008

USD/INR went up, and contracts

USD/INR went up, and ZeroCost

booked at 39.00 were in loss.

Structures booked at 41.00 were

in loss

Where there are no underlyings ,

FX Loss adds to business loss, as
corporate has to buy the

Some arithmetic of Forwards and Zero

Cost Structures
Forward Contracts

Zero-Cost Structures

Exporter books 2 $ forward at 1 $

= Rs 39.00

Exporter buys a Zero Cost

Structure:
1 $ PUT @ 1 $ = Rs 41.00
2 $ CALL @ 1 $ = Rs 41.00

On Due Date : 1 $ = Rs 39.00

On Due date : 1 $ = Rs 39.00

Exporter delivers $ 2 at Rs 39.00

Buyer of CALL does not excercise

Fx P/L ( Rs 39.00 39.00 ) = NIL

option at Rs 41.00

Total Profit : NIL

Exporter sells 1 $ unhedged

underlying @ 1 $ = Rs 39.00
Exporter exercises PUT, and
delivers underlying 1 $ @ 1 $ =
Rs 41.00
Gain on PUT (41.00-39.00) = Rs