4 Factors that Determine Forward Margin in Exchange Rates
When an exporter quotes his price to the importer, he bases his calculations on his cost of production and the profit he expects on the deal. The amount thus arrived is converted into the foreign currency at the prevailing rate of exchange. But, by the time he executes the contract and tenders documents for pur-chase by the bank, the rate of exchange might have turned adverse for him.
Therefore, when he actually ships the goods he may receive less than his expectation. It is also possible that the rate may turn favorable and he may receive more than his expectation. Still the fact remains that the amount that he would receive on execution of the contract remains uncertain. This uncertainty about the rate of exchange that would prevail at a future date is known as the exchange risk.
Forward contract is a device to cover the exchange risk. At the time of entering into the contract, the exporter also enters into a forward contract with his bank for the amount of the contract. It means he agrees to sell to the bank a bill drawn on the importer at a future date and the bank on its part agrees to purchase the bill at a rate of exchange agreed on the date of entering into the contract. When the exporter submits his bill under the contract, the bank would purchase it at the rate agreed irrespective of the spot rate then prevailing.
The exporter is thus certain about the amount that he would receive under the export contract. The forward rate is quoted at a difference over the spot rate. The difference between the spot rate and the forward rate is known as the forward margin. If the forward margin is at premium it means the currency is costlier under the forward rate than under the spot rate. If the forward margin is at discount, it means the currency is cheaper under the forward rate than under the spot rate.
Factors Determining Forward Margin
Many factors affect the forward margin, chief among which are discussed as follows:
1. Rate of Interest. The difference in the rate of interest prevailing in the home center and the concerned foreign center determines the forward margin. If the rate of interest in the foreign center is higher than that prevailing in the home center, the forward margin would be at discount. Conversely, if the rate of interest at the foreign center is lower than at the home center, the forward margin would be at premium.
This can he explained thus: When the bank enters into a forward sale contract with the customer, it arranges for delivery of the foreign currency on the due date by keeping the funds in deposit at the foreign center concerned. If the interest rate is higher at the foreign center concerned, the net gain to the bank is passed on to the customer by offering the forward rate at a discount.
If the interest rate is lower at the foreign center, the bank suffers a net loss and the loss is passed on to the customer by quoting the forward rate at premium. If stable conditions prevail in the market, the rate of interest would exert a greater influence than any other factor and forward margin would tend to settle at a rate where the gain/loss in the interest rate differential is fully compensated by the forward margin.
But in practice it is hard to find this and the forward margin at any particular time is determined by other factors listed below.
2. Demand for and supply of forward currency. If the demand for forward currency is more than its supply, the forward rate would be at premium. If the supply exceeds the demand, the forward rate would be at discount.
3. Speculation about spot rates. Since the forward rates are based on spot rates any speculation about the movement of spot rates would influence forward rates also. If the exchange dealers anticipate the spot rate to appreciate, the forward rate would be quoted at premium. If they expect the spot rate to depreciate, the forward rates would be quoted at the discount.
4. Exchange regulations. Exchange control regulations may put some conditions on the forward dealing and may obstruct the influence of the above factors on the forward margin.