Forward Contracts : As you have learnt that entering into forward contract is one of the important method of dealing with the foreign exchange risk. Let us also remind you that in forward contracts two parties enter into the contract for selling or buying of foreign currency in future.
The banks are willing to provide forward cover for the risks arising out of fluctuations in exchange rates to both the importers and exporters. Let us understand it with the help of an example. If the exporter expects to receive, say, dollars after three months, he can approach his banker to purchase dollars forward for him at the forward rate prevailing on the day of the contract. This way he will ensure his export proceeds In terms of rupees. Of course, he will lose possible benefits of any appreciation of dollar by so covering his risk. But the exporter is basically interested in making a profit on exports and not a profit on fluctuations in exchange rates which is the business of speculators in foreign exchange.
Similarly, an importer expecting to make a payment, say, in dollars after three months, can approach his banker to sell him dollars forward at the forward rate prevailing on the day of the contract. This way he will ensure the rupee cost of his imports. Of course, like an exporter, he will lose possible benefits of a reduction in his cost due to depreciation in dollars.
Forward contra& do have a cost. The banks will charge some commission. In addition, they will take into account the premium or discount the forward rate has over the spot rate. Again, a forward contract is a contract which has to be fulfilled by delivering or purchasing the foreign exchange from the bank exactly at the due date. In case it is not done, the exporter importer will have to pay penalty/compensation to the bank.
The banks, however, allow the exporter to have an option forward contract in place of a fixed forward contract. In fixed forward contracts, foreign exchange has to be delivered on the fixed day. In real situations, it may not be possible to do so. At best, you can estimate the probable date. To obviate this difficulty, the customer may be given a choice of delivering foreign exchange during a given period of time. This IS called an option forward contract. Rate is known as the option forward rate period is known as option period. Let us discuss them in detail.