RELATIONSHIP BETWEEN SPOT AND FORWARD RATES

A study of the relationship between spot and future rates would help in determining the degree and the
extent of predictability of the former on the basis of the latter.
The collective judgment of the participants in the exchange market influences the appreciation or
depreciation in the future spot price of a currency against other currencies. The forward premium or
discount is also affected by the interest rate differential between two countries, differences in the
rates of inflation between them, and the degree to which inflation rate differential is translated into interest
rate differential in the expected time horizon. Moreover, the relationship between spot and forward rates
may be affected by the efficiency of the financial and exchange markets in two countries. Controls,
restrictions and other interventions which can affect adjustments in exchange, and interest and inflation
rates differential also influences the spot and forward rates.
Theoretically, in the (i) efficient market and (ii) absence of intervention or control in the exchange or
financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements
are, generally, satisfied if the following three conditions are found:
(i) Interest Rate Parity: According to interest rate parity principle, the forward premium (or discount) on
currency of a country vis--vis the currency of another country will be exactly offset by the interest rate
differential between the countries. The currency of the country with lower interest rate is quoted at a
forward premium and vice-versa.
(ii) Purchasing Power Parity (PPP): According to the PPP Principle, the currency of a country will
depreciate vis--vis the currency of another country on the basis of differential in the rates of inflation
between them. The rate of depreciation in the currency of a country would roughly be equal to the excess
inflation rate in the country over the other country.
(iii) International Fisher Effect: The interest rare differential between two countries, according to the Fisher
effect, will reflect differences in the inflation rates in them. The high interest country will experience higher
inflation rate.
It should, however, be noted that even if these conditions are satisfied, the future spot rate
might not be identical to the forward rate. Random differences between the two rates may
be found.

The Spot Market

The spot market is the exchange market for payment and delivery today. In practice, "today"
means today only in the retailer tier. Currencies traded in the wholesale tier spot market have
customary settlement in two business days.

A forward transaction can be classified into two classes: outright and swap. An outright
forward transaction is an uncovered speculative position in a currency, even though it might be
part of a currency hedge to the other side of the transaction. A foreign exchange swap transaction
helps to reduce the exposure in a forward trade. A swap transaction is the simultaneous sale (or
purchase) of spot foreign exchange against a forward purchase (or sale) of approximately an
equal amount of the foreign currency.
Forward Transaction: On the other hand, the deal will be struck on a particular day, wherein rate
will be agreed upon. But the actual transaction will take place at a specified future date. This is called
Forward Transaction. The Forward Transaction may be for one month, two months or even three
months. This means, the actual contract will take place on a particular day. This forward contract for
delivery of currencies will take place after one month, two months or three months decided according
to the contract.

Meaning and Factors of Forward Margins/Swap Points

Spot Market The term spot exchange refers to the class of foreign exchange transaction which
requires the immediate delivery or exchange of currencies on the spot. In practice the settlement
takes place within two days in most markets. The rate of exchange effective for the spot transaction is
known as the spot rate and the market for such transactions is known as the spot market.
Forward Market The forward transactions is an agreement between two parties, requiring the
delivery at some specified future date of a specified amount of foreign currency by one of the parties,
against payment in domestic currency be the other party, at the price agreed upon in the contract. The
rate of exchange applicable to the forward contract is called the forward exchange rate and the
market for forward transactions is known as the forward market.
The foreign exchange regulations of various countries generally regulate the forward exchange
transactions with a view to curbing speculation in the foreign exchanges market. In India, for
example, commercial banks are permitted to offer forward cover only with respect to genuine export
and import transactions.
Forward exchange facilities, obviously, are of immense help to exporters and importers as they can
cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward
exchange contract.
With reference to its relationship with spot rate, the forward rate may be at par, discount or
premium.
If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the
contract the forward exchange rate is said to be at par.
The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot rate
when one dollar buys more units of another currency, say rupee, in the forward than in the spot rate
on a per annum basis.
The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate
when one dollar buys fewer rupees in the forward than in the spot market. The discount is also
usually expressed as a percentage deviation from the spot rate on a per annum basis.
The forward exchange rate is determined mostly be the demand for and supply of forward exchange.
Naturally when the demand for forward exchange exceeds its supply, the forward rate will be quoted
at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the
rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange,
the forward rate will tend to be at par.
Futures
While a focus contract is similar to a forward contract, there are several differences between them.
While a forward contract is tailor made for the client be his international bank, a future contract has
standardized features the contract size and maturity dates are standardized. Futures cab traded only
on an organized exchange and they are traded competitively. Margins are not required in respect of a
forward contract but margins are required of all participants in the futures market an initial margin
must be deposited into a collateral account to establish a futures position.

Forward Contract
Forward contracts are typical OTC derivatives. As the name itself suggests, forward are transactions
involving delivery of an asset or a financial instrument at a future date. One of the first modern to

arrive contracts as forward contracts ere known was agreed at Chicago Boar of Trade in March 1851
for maize corn to be delivered in June of that year.
Characteristics of forward contracts
The main characteristics of forward contracts are given below;
They are OTC contracts
Both the buyer and seller are committed to the contract. In other words, they have to take deliver
and deliver respectively, the underlying asset on which the forward contract was entered into. As
such, they do not have the discretion as regards completion of the contract.
Forwards are price fixing in nature. Both the buyer and seller of a forward contract are fixed to
the price decided upfront.
Due to the above two reasons, the pay off profiles of the borrower and seller, in a forward
contract, are linear to the price of the underlying.
The presence of credit risk in forward contracts makes parties wary of each other. Consequently
forward contracts are entered into between parties who have good credit standing. Hence forward
contracts are not available to the common man.
FORWARD EXCHANGE CONTRACT
In the previous chapter, we have already discussed the forward exchange rate and the context in
which it arises etc. Here our interest is to understand how the forward exchange rate is entered into
and the problems associated with it.
A forward exchange contract is a mechanism by which one can ensure the value of one currency
against another by fixing the rate of exchange in advance for a transaction expected to take place at a
future date. It is a tool to protect the exporters and importers against exchange risks. The uncertainty
about the rate which would prevail on a future date is known as exchange risk. From the point of an
exporter the exchange risk is that the foreign currency in which the transaction takes place may
depreciate in future and thus the expected realization will be less in terms of local currency. The
importer also faces exchange risks when the transaction is designated in a foreign currency. In this
case the foreign currency may appreciate and the importer may be compelled to pay an amount more
than that was originally agreed upon in terms of domestic currency.
In the case of forward exchange contract two parties, one being a banker from one country entering
to a contract to buy or sell a fixed amount of foreign currency on a specified future date or future
period at a predetermined rate. The forward exchange contracts are entered into between a banker
and customer or between two parties.
FEATURES OF FORWARD EXCHANGE CONTRACT
The following are the features of a forward exchange contract. FEDAI has also laid down certain
guidelines defining certain aspects of forward exchange contract.
a) Parties: There are two parties in a forward exchange contract. They can be,
1) A bank and a customer.
2) Two banks in the same country.
3) Two banks in different countries.
b) Amount: forward exchange contracts are entered into for a definite sum expressed in foreign
currency.

c) Rate: the rate at which the conversation of foreign exchange is to take place at a future date is
agreed upon at the time of signing the forward contract which is known as the contracted rate and is
to be mentioned in the contract.
d) Date of Delivery: Date of delivery in a forward contract means the future date
on which the delivery of foreign exchange is to take place and is computed from the spot date or date
of contract. However in practice, date of delivery is computed from the spot date and hence if a
forward contract is signed on 30th Oct with spot date as Nov, 2005 for 2months forward. The date of
delivery is Jan 1, 2006.
In India Rule7, FEDAI has laid down certain guidelines regarding date of delivery under forward
contract.
In the case of bills/documents negotiated, purchased or discounted-date of negotiation, purchase or
discount and payment of rupees to customer. In the case of bills/documents sent for collection, date
of payment of rupees to the customer on realization of bills.
In case of retirement /crystallization of import bills/documents-the date of retirement /crystallization
of liability whichever is earlier.
e) Option period: in India FEDAI under Rule 7 has laid down guidelines for option period. The
option period of delivery in an option forward contract should be specified as a calendar week that is
1st to 7th, 8th to 15th, 16th to 23rd or 24th to last working day of the month or a calendar fortnight that is
15th or 16th to last working day the month. If the fixed date of delivery or the last date in an option
forward contract happens to be a holiday, the delivery shall be effected/delivery option exercised on
the preceding working day.
f) Option of delivery: In all option forward contracts the merchant whether a buyer or a seller will
have the option of delivery.
g) Place of delivery: All contracts shall be understood to read to be delivered or paid for at the
bank and at the named place. That is, the contractual obligations under a forward exchange
contract like delivery of foreign exchange or payment are to be executed at the specified branch of
the bank.
FEDAI GUIDELINES FOR FORWARD CONTRACTS: RULE NO 7
Exchange contracts shall be for definite amount.
Unless date of delivery is fixed and indicated in the contract the option period of delivery should be
specified as calendar week or calendar fortnight or calendar month.
If the fixed date of delivery or last date of delivery option is a holiday, the delivery has to be
effected on the preceding working day.
Place of delivery is always at the Bank and at the named place.
Option of delivery is always that of the merchant.
The minimum commission is Rs 250 for booking a forward contract.
Minimum charge is Rs 100 for every request of early delivery extension/cancellation.
Fixed and Option Forward Contracts
Under the fixed forward contract the delivery of foreign exchange should take place on a specified
future date. Then it is known as fixed forward contract. Suppose a customer enters into a three
months forward contract on 5th January with his bank to sell Euro 15,000, then the customer would
be presenting a bill or any other instrument on 7 th April to the bank for Euro 15,000. The delivery of
foreign exchange cannot take place prior to or later than the determined date.

Though forward exchange is a mechanism wherein the customer tries to over come the exchange
risk, the purpose will be defeated if the delivery of foreign exchange does not take place exactly on
the due date. Practically speaking, it is not possible for any exporter to determine in advance the
precise date on which he will be tendering export documents for reasons which are internal relating
to production. Besides internal factors relating to production many other external factors decide
decide the date on which he is able to complete shipment and present documents to the bank. More
often, what is possible for the exporter is only estimate the probable date around which he would be
able to complete his commitment.
Under such circumstances, just to avoid the difficulty of fixing the exact date for delivery of foreign
exchange, the customer may be given a choice of delivering the foreign exchange, during a given
period of days. Such an arrangement whereby the customer can sell or buy from the bank foreign
exchange on any day during a given period of time at a predetermined rate of exchange is known as
Option Forward Contract. The rate at which the deal takes place is the option forward rate. For
example, on 10th June a customer enters into two months forward sale contract with the bank with
option over August. It means the customer can sell foreign exchange to the bank on any day between
1st August and 31st August In the example, the period during which the transaction takes place is
known as the Option Period.
Cancellation/Extension of forward contract
The customer is having the right to cancel a forward contract at any time during the currency of the
contract. The cancellation is governed by Rule 8 of the FEDAI. The difference between the
contracted rate and the rate at which the cancellation is done shall be recovered or paid to the
customer, if the cancellation is at the request of the customer. Exchange difference not exceeding
Rs.50 shall be ignored. The spot rate is to be applied for cancellation of the forward contract on due
date. The forward rate is to be applied for cancellation before due date. In the absence of any
instruction from the customer, contracts which have matured shall on the 15 th day from the date of
maturity be automatically cancelled. If the 15 th day falls on a holiday or Saturday the cancellation
will be done on the next succeeding working day. The customer is liable for recovery of cancellation
charges and in no case the gain is passed on to the customer since the cancellation is done on account
of customers default.
The customer may approach the bank for cancellation when the underlying transaction becomes
infractions, or for any other reason he wishes not to execute the forward contract. If the underlying
transaction is likely to take place on a day subsequent to the maturity of the forward contract already
booked, he may seek extension in the due date of the contract. Such requests for cancellations or
extension can be made by the customer on or before the maturity of the forward contract.
Cancellation of Forward Contract on Due date
When a forward purchase contract is cancelled on the due date it is taken that the bank purchases at
the rate originally agreed and sells the same back to the customer at the ready TT rate. The difference
between these two rates is recovered from/paid to the customer. If the purchase rate under the
original forward contract is higher than the ready T.T selling rate the difference is payable to the
customer. If it is lower, the difference is recoverable from the customer. The amounts involved in
purchase and sale of foreign currency are not passed through the customers account. Only the
difference is recovered/paid by way of debit/credit to the customers account.
In the same way when a forward sale contract is cancelled it is treated as if the bank sells at the rate
originally agreed and buys back at the ready T.T buying rate. The difference between these two rates
is recovered from/paid to the customer.
Early Cancellation of a Forward Contract:

Sometimes the request for cancellation of a forward purchase contract may come from a customer
before the due date. When such requests come from the customer, it would be cancelled at the
forward selling rate prevailing on the date of cancellation, the due date of this sale contract to
synchronize with the due date of the original forward purchase contract. On the other hand if a
forward sale contract is cancelled earlier than the due date, cancellation would be done at the forward
purchase rate prevailing on that day with due date of the original forward sale contract.
Extension on Due date
An exporter finds that he is not able to export on the due date but expects to do so in about two
months. An importer is unable to pay on the due date but is confident of making payment a month
later. In both these cases they may approach their bank with whom they have entered into forward
contracts to postpone the due date of the contract. Such postponement of the date of delivery under a
forward contract is known as the extension of forward contract.
The earlier practice was to extend the contract at the original rate quoted to the customer and recover
from him charges for extension. The reserve bank has directed that, with effect from16.1.95 when a
forward contract is sought to be extended, it shall be cancelled and rebooked for the new delivery
period at the prevailing exchange rates.
Forwards:
Forwards are non-standardised contracts between two parties to buy or sell an asset at a
specified future time at a price agreed today. For example, pension funds commonly use
foreign exchange forwards to reduce FX risk when overseas currency positions are required
at known future dates. As the contracts are bespoke they can be for non-standardised
amounts and dates, eg delivery of EUR 23,967 against payment of USD 32,372 on 16
January 2014.

Since the foreign exchange rate will be fluctuation, the spot rate of the currency will not be the same
at a future date, i.e., after one month or so. If the forward rate and spot rate happen to be the same,
then it is called at par. That is forward rate is at par with spot. This will be very rate in foreign
exchange transactions, unless the currencies in question are steady and stable for a pretty long time.
Generally the forward rate of a currency will be costlier or cheaper than spot rate. The difference
between the spot rate and the forward rate is known as Forward Margin, otherwise called Swap
Points. The forward margin may be either at premium or at discount. In the former case, the forward
rate will be cheaper than the spot rate. Under direct quotation, premium is added to spot rate to arrive
at the forward rate. This is done for both purchase and sale transaction. Discount is deducted from the
spot rate to arrive at the forward rate.
Factors Determining Forward Margin
In this section, we shall briefly study about the factors that determine the forward margin.
Rate of Interest
The prevailing rate of interest at home and also in the foreign country from which we want to get
foreign exchange decide the forward margin. To put it shortly, it depends upon the differences in the
rate of interest prevailing at the home centre and the concerned foreign centre. If the rate of interest at
the foreign centre is higher that the rate of interest prevailing at home centre, naturally, the interest
gained by investing in the foreign centre will be more than the interest gained at home centre. If the
rate of interest at the foreign centre is higher than the home centre, the forward margin would be at
discount. Conversely if the rate of interest is lower in the foreign centre and higher in the home
centre, the forward margin would be at premium.
Demand and Supply of Foreign Currency
This is similar to the principle of demand and supply of a commodity. If a particular foreign currency
is in great demand than its supply, then, naturally, it will be costlier and it will be sold at a premium.
If the supply exceeds the demand, the forward rate will be at a discount.
Investment Activities
Another factor influencing forward margin will be due to the hectic activities of investments, taking
advantage of differences in the rate of interest between one centre and another. The investor may
borrow from low interest centre and invest the amount in the high interest centre. For example, the
investor may borrow at London at the rate of 5% p.a. and invest the amount in Chennai at 12% p.a.
In order to secure his position, he may cover up his transaction in the forward marker. Then, he will
sell spot pound-sterling and buy forward pound-sterling. When many investors do like this, the
supply of spot Pound-Sterling increases abundantly putting down the price. The demand for forward
pound-sterling increases, pushing up the price.
Speculative Activities Regarding Spot Rates
The forward rates are based on spot rates. Any speculation in the movement of spot rates would also
influence forward rates. If exchange dealers anticipate spot rate to appreciate, they will quote forward
rate at a premium. If they expect the spot rate to depreciate, the forward rate would be quoted at a
discount.
Factors Determining Spot Exchange Rates
The most vital factor in foreign exchange is the determination of spot exchange rate. It is on this, all
other activities revolve. We know that forward margin is determined by adding premium or
subtraction discount with reference to spot rate. The spot exchange rate is not determined by a single
factor. It is the combination of several factors which act either concurrently or independently in
determining the spot rate. Let us discuss about these factors.
Balance of Payments

A study of International Trade and Consequent Balance of Payments between countries will
determine the value of the currencies concerned. We know that in international trade exports from a
country, both visible and invisible represent the supply side of foreign exchange. On the contrary,
imports into a country, both visible and invisible create demand for foreign exchange. Let us
illustrate with an example. Suppose India is making lot of exports to USA (both visible and also
invisible). The Indian exporters have to receive Rupeepayment from USA and the
importing merchants in USA would be offering lot of US dollars in exchange for
rupees for payment to Indian merchants. Thus, there will be lot of supply of US
dollars from the point of view of India and lost of demand for Indian rupees from
the point of view of USA. Thus exports represent supply of Dollar demanding
Rupees. When there is lot of supply of dollar, demanding rupees, the value of
Rupee will automatically go up. On the other hand, if India imports more, we
have to pay Dollars to USA merchants. This means, we will offer lot of Rupees,
demanding Dollars. In that case, the value of Dollar will go up comparative to
Rupees. In other words Put if differently, the exporters would offer foreign
currencies in the exchange market, they have acquired, and demand local
currency in exchange. Similarly, importers would offer local currency in
exchange for foreign currency.

The Spot and Forward Foreign Exchange Rates:

There are two types of foreign exchange rates, namely the spot rate and forward rates ruling in the
foreign exchange market. The spot rate of exchange refers to the rate or price in terms of home
currency payable for spot delivery of a specified type of foreign exchange. The forward rate of
exchange refers to the price at which a transaction will be consummated at some specified time in
future. In actual practice there is mot one but many spot rates of exchange; the spot rate for cables
being different from the one applicable to cheques and commercial bills.
In modern times the system of forward rate of foreign exchange has assumed great importance in
affecting the international capital movements and foreign exchange banks play an important role in
this respect by matching the purchases and sales of forward exchange on the part of would be
importers and would be exporters respectively. The system of forward foreign exchange rate has
actually been developed to minimize risks resulting from the possibility of fluctuations over time in
the spot exchange rate to the importers and exporters. An example would illustrate this point.
Suppose that a radio dealer in India wants to import radios from England. The foreign exchange rate
at the moment is Rs.18 for a pound sterling and at this rate the Indian radio dealer calculates that he
could import the radios, pay the customs duty on them, sell them in India, pay the sterling price of
the radios and make a profit on them. But by the time the radios have been shipped across the ocean,
exhibited in Mumbai, sold and paid for, several months will have elapsed and the foreign exchange
rate may now be Rs. 20 for a pond-sterling in which case he has to pay Rs. 2 more for each pound
sterling of the price of the radio and in place of expected profits he may realize actual losses. In other
words, the transaction will be profitable only if the Indian exporter can import radios at an exchange
rate of 18 rupees for a pound sterling.
The forward foreign exchange rate market gives him this assurance. His band will sell him three
months forward pound-sterling at Rs. 18 per pound sterling by charging a slight premium. That
means that the bank undertakes to sell the named quantity of the pound sterling at and exchange rate
of Rs. 18 per pound sterling in three months time, whatever the rate of exchange in the exchange
market may be when that time comes. Similarly, persons who expect to receive sums in foreign
currency at future dates are able to sell forward exchange to the banks in order to be sure in

advance exactly how much they will receive in terms of home currency. The basic importance of
forward rate of exchange flows from the fact that actual rate of exchange is liable to fluctuate from
time to time and this renders the purchase and sale of goods abroad risky. Forward exchange rate
enables the exporters and importers of goods to know the prices of their goods which they are about
to export or import.

A Comparision Between Future and Forward Markets:

As a common trend and general preference, it is most unlikely that the investors would ever involve
in the forward market, it is important to understand some of the attitudes, particularly as a good deal
of the literature on pricing futures contracts typically refers to those contracts interchangeably.
Specially differences resulting from liquidity, credit risk, margin, taxes and commissions could cause
futures and forward contracts not to be priced identically. For example, in dealing with price risk,
futures contracts have several advantages of transaction in comparision to forward contracts.
Sequential spot contracts, which is also known as spot contracts where the terms of the contract are
re negotiated as events unfold, do not inject any certainty into the transaction. Such a method of
contracting is particularly liable to the hazards of opportunism and may deter investment because of
the relatively high probability that the contract will be breached. But the forward and futures
contracts inject some certainty into their transaction. In both of these, there is a similarity that the
parties agree to perform the terms of the contract at some future date. Time dated contracts are
generally costlier to enforce than spot contracts. This is so because of the absence of the self
enforcing exchange of value characteristic of spot transactions and the greater uncertainty attached
both to the eventual outcome and each partys compliance with the term of forward contract.
There are some differences between futures and forward contracts. The difference is more susceptible
to opportunism, especially in their role of reducing price risk. Forward contracts that cover all
feasible contingencies are costly specified forward contract and this contractual incompleteness will
give rise to enforcement and execution difficulties. Some of the difficulties are listed below:
1. Individuals will have to incur the expense of determining the reliability risk of the opposite party
in the forward contract.
2. Forward contracts are also subject to high enforcement costs where personal markets are weak.
3. Forward contracts are tied contracts.
Forward Market:
1. Trading is done by telex or telephone, with participants generally dealing directly with brokerdealers.
2. All contract terms are negotiated privately by the parties.
3. Participants deal typically on a principal -to-principal basis.
4. Participants are primarily institutions dealing with one other and other interested parties dealing
through one or more dealers.
5. A participant must examine the credit risk and establish credit limits for each opposite party.
6. Typically, no money changes hands until delivery, although a small margin deposit might be
required of non dealer customers on certain occasions.
7. Settlement occurs on date agreed upon between the parties to each transaction.

8. Forward positions are not as easily offset or transferred to other participants.

9. Most transactions result in delivery.
10. No commissions is typically charged if the transaction is made directly with another dealer. A
commission is charged to both buyer and seller, however, if transacted through a broker.
11. Trading is mostly unregulated.
12. The delivery price is the forward price.
After having distinguished the forward and the future markets it is important to know the operations
in these markets. For this we have to first see that what is currency quotes and as to how to read the
currency future quotes. First of all we will see that what is meant by currency future quotes.
Currency future quotes can be understood better with the help of the following table.
PDF Page 241 Foreign ex. Mkt.3
The above table is a reproduction of currency-futures quotations that is normally
found in most business newspapers. These futures are contracts for delivery of a
standard amount of a foreign currency in exchange for delivery of a standard
amount of a foreign currency in exchange for delivery of a given amount of U.S.
dollars at some future date. The funds to be exchanged may be, for example,
125000Euro in exchange for the equivalent value in dollars. The figure offers a
guideline for interpretation of published future quotations. As in the forward
market, each delivery takes place in the currency of the country, although as a
matter of practice few deliveries actually occur. The futures contract can be
used to hedge, speculate or perform arbitrage in much the same way as
forwards are used. Many commercial and investment banks are members of the
major futures exchanges and are able to buy currencies in the forward market
and sell them in the futures markets, and vice-versa, ensuring that futures
prices stay in line with forward prices for the same delivery date.
Hedging with Currency Futures and Contracts:
With the following options the foreign currency can be hedged.
1. By going long in a currency call option, the investor can lock in the maximum dollar costs of a
future cash outflow or liability denominated in a foreign currency while still maintaining the chance
for lower dollar outlays if the exchange rate decreases. In contrast, by going long in a currency put,
the investor can lock in the minimum dollar value of a future inflow or asset denominated in foreign
currency while still maintaining the possibility of a greater dollar inflows in case the exchange rate
increases. With foreign currency futures and forward contracts, the domestic currency value of future
cash flows or the future dollar value of assets and liabilities denominated in another currency can he
locked in. Unlike Option hedging,
however, no exchange rate gains exist when futures or forward contracts are used.
2. Hedging Future Currency Cash Flows With A Nave Hedge
Large multinational corporations usually hedge their currency positions in the inter-bank forward
market, whereas smaller companies, some portfolio managers, and individuals often use the futures
market. Either way, the currency position usually is hedged with a nave hedging model in which the
number of futures or forward contracts is equal to the value of the foreign currency position to be
hedged.

To illustrate currency hedging, consider the option hedging example presented above in which a U.S
company expected a receipt of 625,000 DM at the end of three months. Instead of hedging with a
DM put, suppose the company decides to hedge its receipt with a DM futures contracts expiring at
the end of three months, currently trading at S f =$0.40/ DM when the spot exchange rate is at S 0
=$0.40/ DM. Since the contract size on the DM futures contract is 125,000 DM, the company would
need to go short in five DM contracts, if it uses a nave hedging approach:
($0.40 / DM) (625,000 DM)
=5
($0.40/ DM) (125,000 DM)
Doing this, the company would, in turn, ensure itself of a $250,000 receipt at expiration when it
converts its 625,000 DM to dollars at the spot $ / DM
exchange rate and closes its short futures position.
If a multinational has a future debt obligation that is required to pay in foreign currency; then it could
lock in the dollar cost of the obligation by taking a long futures or forward position. This hedging
strategy where the dollar costs of purchasing 625,000 DM at the end of three months is hedged with
five long DM contracts priced at Sf=$0.40 / DM. In this case, the net costs of purchasing the Maria
on the spot and closing the futures is $250,000, regardless of the spot exchange rate.
Currency Options for whom i.e. who needs Currency Options
Currency options are useful for all those who are the players or the users of the foreign currency. This
is particularly useful for those who want to gain if the exchange rate improves but simultaneously
want a protection it the exchange rate deteriorate. The most the holder of an option can lose is the
premium he paid for it. Naturally, the option writer faces the mirror image of the holders picture: if
you sell an option, the most you can get is the premium if the option dies for lack of exercise. The
writer of a call option can face a substantial loss if the option is exercised: he is forced to deliver a
currency-futures contract at a below-market price. If he wrote a put option and the put is exercised,
then he is obliged to buy the currency at an above-market price.
Foreign exchange options present an asymmetrical risk profile unlike futures, forwards and currency
options. This lopsidedness works in favor of the holder and to the disadvantage of the writer. This is
why because the holder pays for it i.e he takes the risk. When two parties enter into a symmetrical
contract ;ole a forward, both can gain or lose equally and neither party feels obliged to charge the
other for the privilege. Forwards, futures, and swaps are mutual obligations; options are one-sided.
The holder of a call has a downside risk limited to the premium paid up front; beyond that he gains
one-for one as the price of the underlying security.