What are Fixed and Option Forward Contracts

Knowledgiate TeamJune 18, 2018

1,559 2 minutes read

Fixed and option forward: A fixed contract is one where the parties agree on the amount and the rate at which the deal will be put through, but the delivery will be made on a predetermined future date. Thus, if on 6th March a customer enters into a three months forward contract with his bank to sell £ 10,000, it means the customer would be presenting a bill or any other instrument on 5th June to the bank for £ 10,000. He cannot deliver foreign exchange prior to or later than the determined date.

In real situations it is not possible for any exporter to deliver foreign exchange exactly on the due date. Besides internal factors relating to production, many other external factors also determine the date on which he would be able to complete shipment and present documents to his bank. At the most he can only estimate the probable date around which he would he able to complete his commitment.

To obviate the difficulty, the customer may be given a choice of delivering the foreign exchange during a given period of time. 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 pre-determined rate of exchange is known as option forward contract.

The rate at which the deal takes place is the option forward rate. For example, on 14th September a customer enters into a two months forward sale contract with the bank with option over December. It means the customer can sell foreign exchange to the bank on any day between 1st December and 31st December. The period from 1st December to 31st December is known as the option period.

Rules regarding Option Forward Contracts

1. The option period of delivery should be specified as a calendar week (i.e., 1st to 7th, 8th to 15th, 16th to 23rd, or 24th to last working day of the month) or a calendar fortnight (i.e., 1st to 15th or 16th to last working day of the month).

2. The option of delivery should not exceed a period of one calendar month, i.e,. from 1st to last working day of the month.

3. As between a bank and a customer the option is that of the customer. So the bank cannot force the customer to deliver foreign exchange on any specific date. It is up to the customer to choose any date within the option period.