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 What is a Forward Contract?

Most of the companies in India who get their payments from foreign countries, in order to avoid risk/to get more conversion rate, sign a particular contract with the banks or with some private financial institutions. Let us assume a company in India, which gets 200,000 USD from their US client every month. This company will be using that 200,000 USD to spend for salary, operation, and maintenance operations in India. Before the current month end, they used to prepare a report for expected expenses in Indian Rupees for the next month. This report will help them to find out the actual US DOLLARS required to meet their expenses. On an average assume that they need 200,000 USD every month for their monthly expenses in India at a conversion rate of 50 rupees for one USD. (i.e.) this company needs 1 crore (200,000 * 50) rupees per month.

Since there is a volatility in the conversion rate (ranging from 45 rupees to 55 rupees), they are not sure about the conversion rate. If the conversion rate becomes 45 rupees, then they will need 222,000 USD (1 crore over 45 rupees, which is approximately 222,000) dollars and they have to manage the remaining 22,000 USD, which becomes a risk factor for them.

Example 1: If a person in India is expecting 1000$ from his relative in USA, then the question is how much INR he will get for one US Dollar. Here the person is comparing the domestic currency with the foreign currency. He will be happy if USD to INR conversion is more.

So they go to a bank, explain their situation and after fulfilling the below two conditions:

  • minimum deposit required (amount depends upon the financial institution).
  • 200, 000 USD should reach their bank from US Client on a specified date in a month

This contract is called as Forward Contract. Upon signing the forward contract, the bank agrees to pay conversion rate of 53 rupees per month, on 5th of every month for the next 12 months.

What do you know from the above contract?

  • There are Two Parties: Bank and Company
  • Amount will be paid for: Next 12 months
  • Amount will be paid on: a specified date
  • Conversion Rate: Pre-Agreed Price

A forward contract is a contract between two parties, where the settlement takes place on a specific date in the future at today's pre agreed price.

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