Question

P Company enters into a forward contract to sell foreign currency. At the contract date, the forward rate is $1.20 and the spot rate is $1.24. BRIEFLY explain why this may not appear to be logical (and it doesn't), and why would P do this anyway.

Answer 1

Expian the terms:

Forward Contracts Meaning -

Right and Obligation to buy/sell assets , commodities etc in future at a price agreed upon today. In Forward Contracts terms customized to the needs of the parties and not traded on the exchange like commodity exchange market.

In Forward Contracts both parties i.e. buyer and seller have respective obligations to buy / sale the assets, commodities etc mentioned in the Contract.

Spot Rate - The spot rate is price at which assets , commodities are CURRENTLY traded and Contracts are settled.

Forward rare - The forward rare is price at which assets, commodities are to be traded in Future and Contracts are to be settled.

ABSWER :

In given question P company enters the forward Contracts to sell foreign currency for forward rate $ 1.20 which is LESS THAN current spot rate of $ 1.24.

From above explanation it is quite clear that P company is selling at LOWER FORWARD RATE as compare to CURRENT SPOT RATE. this situation will lead to approximately loss of $ 0.04 per unit of foreign currency.

This seems completely illogical for P company to enter into forward Contract at such lower forward rate BUT for reason given below may justified P company's position.

Reason

Let's assume that P company has no physical inventory of foreign currencies at the moment to take advantage of higher spot rate so, P can not sell any foreign currencies at present time but P company has Forward Purchase Contact of foreign currencies with other party at lower forward rate than selling forward rate. As we all know in Forward Contracts there is no physical inventory required at time of entering into the forward Contracts.

So, we can assume that P company has entered into forward sale contract at lower than spot rate to gain the advantage of Forward Purchase contract made with other party at lower rate.