Meet Mohan. He is a farmer by profession. He grows rice in a small village in Haryana. He sows seeds in the month of February and harvests his crop in April every year. Whenever there is scarcity of rice in the state, he sells his stuff at a high price. But when the market is glutted with rice, he takes a hit and has to dispose of his crop at a throwaway price. Risky business that, eh?
Sohan runs a rice mill in a neighbouring village. He purchases the rice crop from farmers like Mohan, removes the husk from the crop and sells the rice in the market. There are years, when due to an oversupply situation he is able to procure rice at a favourable price. On the other hand, in times of scarcity, he has to purchase rice at an exorbitant price. So, his business is equally fraught with risk.
One February few years back, Mohan expected the price of rice to drop to Rs10 per kilo by April that year due to oversupply in the market. However, Sohan expected rice prices to rise to Rs15. Mohan made up his mind to sell his crop at any price higher than Rs10. On the other hand, Sohan was prepared to purchase rice at any price below Rs15.
They bump into each other at a cattle fare in Mohan's village. Soon they get talking and exchange views on their respective businesses. They learn about each other's view on the rice price too. To escape the risk associated with the price of rice, they enter into a deal as per which Mohan agrees to sell rice to Sohan at a pre-determined price of Rs12.50 per kilo. In other words, they entered into a forward contract. Though they sign the deal in February, the actual transaction is carried out in the month of April only.
But what is forward contract?
Well, it is an agreement to buy and sell an asset at a certain time in the future at a predetermined price.
Now, consider this. If the price of rice had remained below Rs12.50 per kilo that April, Mohan would have made a profit and Sohan, a loss. But if the rice price had crossed Rs12.50, Sohan would have made a neat profit and Mohan would have taken a hit.
But thanks to the future contract, nobody would have suffered a loss even if the price had gone against their expectations.
It's a win-win situation for both
How? After entering into the forward contract, Mohan could budget his general spending on the basis of the money that he would receive by selling rice to Sohan in April. At the same time, Sohan, knowing his raw material (rice) cost in advance, could also work out the selling price of the clean rice. Hence, forward contract helped both the participants do away with all risks associated with the price of rice.
A forward contract not only helps one reduce the price risk associated with commodities but also eliminates the interest rate risk and foreign exchange risk.
Assume that your company is planning to expand its operations. It expects to do so in the next two months and will need about Rs200cr to do so. However, the finance manager of your company is not sure as to what the interest rate will be like in the next two months. It may go up, in which case his company will have to borrow at a rate higher than the existing rate. It may even drop; in which case his company will benefit for it will be able to borrow at a lower cost.
So, what does the finance manager do?
Smart that he is, he approaches his company's bank and enters into a two-month forward contract for Rs200cr at a certain fixed rate. This forward contract is called Forward Rate Agreement (FRA). So, how does the finance manager benefit? Knowing in advance the interest rate at which his company will borrow, helps him work out the finance cost of the expansion project. And hence, the viability of the project.
And how does a Forward Contract help eliminate forex risk?
As you all know rupee depreciation hits importers while appreciation of the rupee affects exporters. However, at a given point of time exporters and importers can remove this uncertainty regarding the rupee's movement by signing forward contracts. How?
Let us understand this better with an example. A textile manufacturer wants to import some textile equipment from the US. It will cost him a total of $1000, which he will have to shell out after two months. The current Rupee-Dollar exchange rate is Rs40 per dollar. But after two months, when the textile manufacturer will be required to make the payment, the Rupee-Dollar exchange rate is likely to be Rs45 per dollar! As is evident, the textile manufacturer's import cost will rise after two months in keeping with the depreciation in the rupee's value. So, how does he avoid this extra cost?
He approaches his bank and enters into a forward contract to buy $1000 after two months at a pre-defined price that is little higher than the existing rate. This helps him know in advance his finance cost and hence eliminates the foreign exchange risk.
But there is one problem regarding a forward contract. Assume that Mohan and Sohan live in two different corners of the country - Mohan in some village in Rajasthan and Sohan, in Tamil Nadu! How would the two meet and transact in such a case? How do they enter into a forward contract? But don't worry. Ever this problem can be solved. How? Wait and watch this place for the solution.
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