The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as ‘fixed forward contract’. For instance, if on 5th March, 20XX a customer enters into a three months forward contract with his bank to sell GBP 10,000 it means the customer would be presenting a bill or any other instrument on 7th June, 20XX to the bank for GBP 10,000. He cannot deliver foreign exchange prior to or later than the determined date.
Basics of forward contract
We saw that forward contract is a device by which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange exactly on the due date. In real situations, it is not possible for any exporter to determine in advance the precise date on which he will be tendering export documents. Besides internal factors relating to production, many other external factors also have a bearing on the date of shipment and presentation of documents to the bank. At the most, the exporter can only estimate the probable date around which he would be able to complete his commitment.
Option contract definition With view to eliminating the difficulty in fixing the exact date for delivery of foreign exchange, the customer may be given an option to deliver the foreign exchange during a given period of days. 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 Contract’. The rate at which the deal takes place is the option forward rate. For example, on 15th September, 20XX a customer enters into two months forward contract with the bank with option over November, 20XX. It means the customer can sell foreign exchange to the bank on any day between 1st November and 30th November 20XX. The period from 1st to 30th November is known as the ‘Option Period'.
