Option Period Vs Fixed Date Forward Contracts: Explained
Many clients we work with, especially SME clients, and more especially Exporters, tend to prefer an â€œOption Periodâ€ Forward Contract rather than a â€œFixed Dateâ€ Forward Contract.
Many clients we work with, especially SME clients, and more especially Exporters, tend to prefer an “Option Period” Forward Contract rather than a “Fixed Date” Forward Contract.
OPTION PERIOD DELIVERY
The “Option Period” Forward Contract is an exotic animal, most likely found only in the Indian forex market. Why do Exporters like this strange hedging instrument so much? What “perceived” benefit does it give them? How does it work? And why is it actually a sub-optimal instrument?
Many exporters do not enjoy the luxury of exporting on the basis of strict L/C terms. As such, many a times they do not know the exact date on which their receivable will materialise. At best they have a rough idea of the time period in which they can expect their customer to send the payment. Hence, when they want to undertake a Forward (Sale) Contract against their receivable, they are unable to give a specific value date for the forward contract to their bank. This is a common problem.
So, the banks have come up with what looks like an attractive, accommodative and customer friendly solution, which is often more profitable for the bank than for the customer. In a magnanimous gesture, the bank “allows” the exporter to deliver the Dollars within a specified period (often a calendar month) instead of on a specific date. For example, on 23rd April, an Exporter who is expecting to receive payment by end of June is allowed to enter into a Forward Contract to sell Dollars to the bank any day between 1st and 30th June. For this, the exporter is entitled to get the Forward Premium for the period 26-April to 31-May, or for little more than 1 month. Note here that the forward period will be counted from 26-April onward since 25-April is the Spot date for 23-April.
The bank, on the other hand, can go out into the market and sells Dollars forward for value date 30-June, instead of value date 31-May! In other words, it sells 2 months 5 days forward gets premium for 66 days (26-Apr to 30-Jun) instead of for 36 days (26-Apr to 31-May).
What happens in case the payment comes in earlier than 30-Jun, say on 15-Jun? Under the Option Period Forward Contract, the exporter simply delivers the Dollars to the bank and is credited with the Forward Rate, as previously agreed, that was then applicable on 23-April, for 31-May. He is unaware of the fact that he has foregone premium for 15 days. What does the bank do, on the other hand? The bank, which had previously “received” premium for the entire period from 26-April to 30-June from the market, “pays” premium for the period 16-June to 30-June, back to the market. On a net basis, therefore, the exporter receives premium for 36 days months whereas the bank receives premium for 51 days.
This is pure profit for the bank, which could as well have been to the account of the Exporter if he had done the same thing as the bank, viz. (1) Sold Forward for fixed date 30-June (2) Given Early Delivery on 15-June and (3) Paid back premium for the period 16-June to 30-June through a swap transaction.
An Early Delivery is a perfectly correct and legitimate transaction, well within the RBI’s guidelines, and has been around for at least two decades, quite possibly longer. Many Exporters do not avail this facility because they are either not aware of this facility or they do not want to take on any additional administrative work.
BAD FOR IMPORTERS ALSO
The Option Forward Contract is bad for the Importer as well. Say on 23rd April, an Importer asks for an option forward contract for the period 01 to 30-June, he is asked to pay premium for the full 66 days from 26-April to 30-June. Instead, he could have asked for a fixed date forward contract for value date 30-June. Then, if has to “take” early delivery of the Dollars from the bank on 15-June, he can ask to be refunded the then prevailing forward premium for 15 days, from 16-
June to 30-June. In this manner he ends up paying premium for only 51 days, instead of for 66 days.
NEED TO WAKE UP
Both Exporters and Importers need to wake up and look at the amount of money they are losing by taking option period forward contracts and not hedging for a fixed date. The average monthly premium over the last couple of years has been 20-30 paise. We can safely assume that roughly half of this is foregone when an Exporter asks a bank for a option period forward contract instead of giving “early delivery” on a fixed date forward contract.
10 paise foregone on every $ 1 million sold every month translates into foregone revenues of Rs 12,00,000/- every year. Is that worth losing? Or is it worth capturing? You decide.