Page 48 - DCOM510_FINANCIAL_DERIVATIVES

Unit 3: Introduction to Forward Contracts

7. The party that agrees to buy an underlying asset (e.g. stock, commodity, stock index, etc.) Notes
in a future date is said to have a short position.
8. Spot position is the quoted price of the underlying asset for buying and selling at the spot
time or immediate delivery.
9. The pre-specified price of the underlying assets at which the forward contract is settled on
expiration is said to be delivery price.
10. The party that agrees to sell an underlying asset (e.g. stock, commodity, indices, etc.) in
future date is said to have a short position.

Case Study Bruin Herbal Products—Forward Hedge

ruin Herbal Products located in India is an old-line producer of herbal teas, seasoning
and medicines. Their products are marketed all over India and in many parts of
BEurope as well.
Bruin Herbal generally invoices in rupees when it sells to foreign customers in order to
guard against exchange rate changes. However, the company has received an order from
a large wholesaler in France for ` 40,00,000 of its products. The condition is that the
delivery should be made in 3 months time and the order invoiced in French francs.

The manager of Bruin herbal is concerned – what if the rupee appreciates versus the franc
over the next three months thus eliminating most of the profit when the French franc
receivable is paid. The manager decides to contact the firm’s banker for suggestions about
hedging the exchange rate exposure.

The banker informs the company that the current Spot exchange rate is 1FFr = ` 6.60, thus
the invoice amount should be FFr 264,00,000. The 90 day forward rate for the rupee and the
French franc versus the US dollar are 1FFr = ` 6.50 and 1$ = ` 42.0283. The banker offers to
set up a forward hedge for selling the franc receivable for rupees based on the cross
forward exchange rate implicit in the forward rate against the dollar.
Question:
What would be your decision if you were the manager of Bruin Herbal Products? Show
the relevant calculations. Interest rate in India = 9%, Interest rate in France = 12%.
Source: Madhu Vij. “International Financial Management”. Excel Books (2010).

3.4 Summary

A Forward Contract is a contract made today for delivery of an asset at a pre-specified
time in the future at a price agreed upon today.
Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-
counter market, usually between two financial institutions or between a financial
institution and one of its clients.

They are over-the-counter (not traded in recognised stock exchanges) derivatives that are
tailored to meet specific user needs.

Forward contracts are bilateral contracts, and hence, they are exposed to counter party
risk.

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