Calculation of Option Forward rates| Forex Management


It may be noted that as between two banks, the option of delivery under a forward contract rests with  buying bank. If the customer delivers foreign exchange on 1st April, the has to pay Yen to the customer immediately. In case the counterpart (buyer) in the cover deal chooses to require delivery on 30th April, the bank has to either keep the dollars received form the customer with itself or invest it for one month. Dollar is at premium because the cost of dollar funds is lower that that of yen funds. For one month, even if the dollar is invested the bank would be losing on the interest differential which has to be compensated by offering lower premium to the customer.
From the above discussion , we may deduce the following rule: for purchase transactions quote premium for the earliest delivery.

Next post we’ll discuses more.

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Forex Management | Option Forward


In fact option forward contract is a part of forex management.  Under an option forward contract the customer has the freedom to deliver the foreign exchange on any day during the option period. The bank should quote a single exchange rate valid for the entire period. Suppose that the following rates prevail for US dollar on 17th February:
      Buying        Selling
        Yen             Yen
Spot             49.45          49.50
Spot/March  0.05            0.06 pm
Spot/ April   0.08             0.09
Spot/ May     0.11            0.12

In respect of purchase transaction, the forward premium for delivery March is 0.05 Yen and for delivery April is 0.08 Yen. We have already seen that normally forward margin is to compensate the interest differential. The additional premium of 0.03 Yen for April over that for March represents the interest differential for one month. If a customer requires forward purchase rate for fixed delivery 30th April, the bank would concede him the premium up to April end, and quote him the rate of Yen.49.53 per dollar. On the other hand , if the customer wants to deliver foreign exchange on 1st April, he is not entitled to the premium for April. The forward premium for April beginning would be the same as that for March end. The bank will therefore quote him a rate of Yen 49.50 , inclusive of premium up to march. Suppose the customer requires the bank to book a forward purchase contract delivery April. It means, the customer can delivery foreign exchange on any day during April. i.e. 1st April to 30th April, but the bank should quote a single rate which would be applicable to any these days. The bank would play safe and quote the rate of Yen 49.50 (i.e. the rate for March) for an option forward contract with option to the customer over the entire April.

It may be argued on behalf of the customer that the option forward rate quoted to him is based on the inter-bank option forward rate as a part of bank’s forex management. The bank would cover itself by entering into a forward sale with the market with option of delivery 1st to 30th April, in which case the premium of 0.08 Yen is available to it.
                                                                                                            
                                                                                                                     

Forex Management and Calculation of Option Forward rates


 

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