Deliverable forwards are a type of forward contract that involves the physical delivery of the underlying currency. These contracts stipulate that the currency seller delivers the specified amount of currency to the currency buyer upon the contract’s maturity date. Deliverable forwards are primarily used to hedge against currency risk in international trade and financial transactions.
Key Characteristics of Deliverable Forwards
Definition and Structure
A deliverable forward is a contractual agreement between two parties to exchange a specified amount of one currency for another currency at a predetermined future date and at a specified exchange rate. Here’s the fundamental formula for the contract’s value at maturity \( V_t \):
where:
- \( S_t \) is the spot exchange rate at time \( t \).
- \( F \) is the forward exchange rate agreed upon in the contract.
- \( r \) is the risk-free interest rate.
- \( t - \tau \) is the time to maturity.
Physical Delivery
Unlike Non-Deliverable Forwards (NDFs), deliverable forwards oblige the parties to physically transfer the currencies on the settlement date. This feature mitigates exchange rate risk by locking in the future exchange rate and ensuring the actual delivery of currencies.
Usage
Deliverable forwards are widely used in:
- International Trade: Companies engaged in exporting or importing goods use these contracts to stabilize costs by locking in exchange rates.
- Financial Management: Financial institutions and multinational corporations employ deliverable forwards to hedge their exposure to foreign exchange risk.
Comparison: Deliverable Forwards vs. NDFs
Deliverable Forwards
- Delivery: Physical delivery of currency.
- Settlement: At contract maturity.
- Use Case: Typically for trade or transactions where the exchange of currency is necessary.
Non-Deliverable Forwards (NDFs)
- Delivery: No physical delivery; settlement in a reference currency.
- Settlement: Based on the difference between the agreed forward rate and the spot rate at maturity.
- Use Case: Used when currency restrictions or capital controls prevent physical delivery.
Historical Context
The concept of forward contracts dates back to ancient trading civilizations but has evolved with global trade complexities. Deliverable forwards gained prominence with modern international trade and the need to manage currency risks effectively.
Applicability
Use in Business
Deliverable forwards are integral to:
- Exporters: Lock in the value of foreign currency receivables.
- Importers: Secure the cost of future foreign currency payment obligations.
- Investors: Hedge against unfavorable currency movements that could impact overseas investments.
Regulatory Considerations
Governments and financial regulatory bodies scrutinize forward contracts to ensure compliance with foreign exchange controls and prevent market manipulation.
Example
A U.S. company expects to receive EUR 1 million from a European client in 90 days. To hedge against the potential depreciation of the Euro, the company enters into a deliverable forward contract to exchange EUR 1 million for USD at a forward rate of 1.2 USD/EUR. On the settlement date, regardless of the spot rate, the company receives USD 1.2 million in exchange for delivering EUR 1 million.
Related Terms
- Forward Rate Agreements (FRA): A FRA is a contract between two parties to exchange interest payments based on a notional principal amount at a future date.
- Swap Contract: A swap involves the exchange of cash flows or other financial instruments between parties, often used for interest rate or currency management.
- Currency Futures: These are standardized exchange-traded contracts to buy or sell a currency at a future date, offering liquidity and potentially lower counterparty risk compared to OTC forwards.
FAQs
1. What happens if the market exchange rate is more favorable than the forward rate at maturity?
2. Are deliverable forwards available for all currencies?
Summary
Deliverable forwards are essential financial instruments for managing currency risks in international trade. By stipulating the physical delivery of currencies at the contract’s maturity, they provide a reliable method for enterprises and investors to hedge against unfavorable currency exchange fluctuations, ensuring financial stability and predictability in cross-border transactions.
References
- Hull, J. C. (2018). “Options, Futures, and Other Derivatives.” Pearson Education.
- Shapiro, A. C. (2013). “Multinational Financial Management.” Wiley.
- Madura, J. (2021). “International Financial Management.” Cengage Learning.
