FORWARD FOREIGN EXCHANGE CONTRACTS AND PRICING

I. Forward Foreign Exchange Contracts: Overview

1.1. Definition and basic concept explanation

They can be described as buy or sell agreements that are entered into on the global financial

markets in a bid to protect against or gamble on future price movements. They are a contractual

arrangement whereby two parties agree to trade an asset in the future on a set price at an agreed

time. Specifically, forward contracts are individualized and are settled directly between the two

contracting parties through an over-the-counter (OTC) market, which makes the contracts more

exception-based but are more susceptible to counterparty risk (Brigo & Mercurio, 2019). It

enables the contract to be drafted to fit the features of the caught case particularly as to the

quantity of the asset, delivery dates and other conditions which indeed can offer a number of

benefits in the management of specific financial risks. A forward contract is a type of derivative

that deals with the speculation and culminates in the agreement of purchasing or selling an asset

at a certain price in the future in order to hedge against future changes in price (Anderson, 2022).

For instance, a company that will be paid in a particular foreign currency after sometime will

employ forward rate to ensure that the amount to be received is going to be of a Certified

amount, regardless of the movement in the specific currency at that particular time. This can be

especially useful for the firms who are already involved in the international trade as this would

assist to smoothen the cash flow and the estimates for the further budgeting. Specifically, like in

the case of interest rate and inflation degree of hedging, both buyers and sellers of commodities

can employ forward contracts, in that they allow for the securing of the delivery price of the raw

material or the price that the final consumer can lock in to receive for the final product. The

determination of forward contracts involves; the spot price of the particular asset being traded,

the risk free rates of the involved currencies, and time to contract maturity. The spot price refers

to the actual going price which a holder of an asset can obtain for it in a current transaction or the

price at which one can acquire the asset. Also referred to as the riskless rate, the risk-free interest

rate is usually provided by government bond yields which is applied in discounting future cash

flows to the present period to factor the time value of money.

1.2. Parties involved in forward contracts

Forward contracts involve two major parties, that is the buyer and the seller; although there roles

and goals differ. Forward contract is a contract through which the buyer commits to purchase the

underlying asset in the future at an agreed price before it becomes evident that the future market

price will be higher than the agreed price and the seller of the forward contract expects to sell the

asset in the future at a lower price than the agreed price. On the other hand, the buyer promises to

purchase the commodity at the said price and in turn relying on the market price to be lower so

that the seller also makes a profit (Bailey & Ng, 2018). Anyone out there wants to take

advantage of the price fluctuation in their favor, helplessly employs the forward contract in an

effort of fixing the price at the desired level. Besides the primary parties involved, there are

other players in the financial system, particularly from the contracting perspective; This is due to

the fact that several financial institutions may also participate in the development and the

settlement of these contracts. These intermediaries, like for example banks or brokerage houses,

have a very strategic function in designing the forward contracts in correspondents with the

requirements of their clients.These financial institutions use forward contracts to hedge on their

own risks within the foreign exchange and derivatives financial markets and options on interest

rates (Bennet & Smith, 2021). They can assess certain risks such as fluctuating exchange rates or

interest rates and end up with more digestible results. Due to the OTC characteristic of these

contracts, the credit worthiness of both parties is essential as a centralized clearing does not exist

hence introducing high possibility of a counter party defaulting. Forward contracts are very

different from futures they are over the counter their beauty lies in the fact that they are

customizable to the customer’s needs and do not involve a clearing house that guarantees the

transaction and hence require the counterparty credit worthiness. This inherent risk held with

each of the arrangements means that each party needs to carry out some research on the part of

the counter party concerned in order to determine that the counter part is financially viable and

credit worthy before entering into the contractual arrangement with the counter part.

1.3. Purpose and applications of forwards

The principal essence of an f-currency is that it eliminates risk in an organization through the use

of the forward contract mainly in relation to exchange rates, commodities and interest

rates. A forward contract can be described as a tool employed in business environments to

manage price risks that can have damaging effects on their performance among investors. For

instance an exporter may need to receive payments in a foreign currency, but due to threat of

depreciation in currency, s/he may engage in forward contract to hedge against this uncertainty(

Bailey & Ng, 2018). Consequently, the exporter is assured of receiving a specific amount in their

home currency by receiving the payment at a particular interval in their home currency; this

directly contributes to financial certainty in trying to budget and plan their finances. Speculative

uses other than hedging are well served by forward contracts where traders purchase the forward

contracts with the aim of selling at a profit following a variation in prices. Such contracts could

be made based on an expectation of the direction that markets will take, with the hope of

obtaining cheap supplies for resale or using them to purchase goods cheaply when the supplies

are plentiful. Speculative use off forward contracts also increases the liquidity of these products

and can be positively informative about future prices at the same time introducing higher risk

than hedging does. Also, another practical use of forward contracts is evident in the application

of theories like interest rate parity, a theory that posits forward exchange rates should help

capture the interest rates differential between two countries implying on their impact on currency

exchange planning (Anderson, 2022). This principle assists in explaining and forecasting

changes in the exchange rate for currencies since it is influenced by interest differentials and any

material change has to be hedged through forward contracts for efficient international business

operations. It means clients make adequate decisions in efforts to exposure of their business to

the other currency to enable them to conduct their cross-border operation with out much risk on

the interest rate differentials.

II. Pricing Forward Foreign Exchange Contracts

1.1. Interest rate parity and pricing

Interest rate parity (IRP) hypothesis postulates that the differential between the interest rates that

prevail in two countries should be equal to the differential between the forward exchange rate

and the current exchange rate so as to correct the deviations in the foreign exchange markets.

This means that the country which has a higher interest rates will have its currency cheaper in the

forward market in the forward market it will have forward discount while the country with lower

interest rates will have its currency more expensive in the forward market, and this will be called

as forward premium (Campa & Chang, 2017). This principle underpins the logical pricing of

forward forex contracts which is relevant for investors and actors in the global markets. For

instance, the investors can use it to measure returns that could be earned by engaging in

borrowing in one currency and investment in another and this reduces the arbitrage risk as noted

by Aliber in 1973 . MNEs use IRP to regulate forex exposure, protect cash flows and to avoid

complaining from volatility in foreign exchange rates (Levi, 2009). Also, the risk involved in

international financial management is the assessment of cross border investments where the

changes in exchange rate measured through the IRP model is used in determining the true and

real cost of return on investment (Solnik & McLeavey, 2004). Despite this decoupling, market

forces can cause deviations from IRP and while it may takre some time, arbitrageurs adjust these

deviations quickly (Taylor, 1987). It just underlines the need for financial professionals to

comprehend and apply the model of IRP for managing foreign exchange risks associated with

International investment. At the same time, IRP is used as a major concept in international

finance curricula to make the students grasp the essence of the relation between interest rates,

exchange rates, and the investment choices. Furthermore, the variations in IRP are closely

observed by the central banks because such variations reflect some breaches in the efficiency of

Fx markets along the other indicators of breaches of the monetary policy implementation

channels which requires intervention (Cheung & Chinn, 2001). Hence, knowledge of IRP is

crucial especially for those dalam who are designing policies for countries’ economic

development, investing in the financial sector or analyzing the performance of organizations in

the international economy.

1.2. Calculating forward rates from spot

The forward rates that are obtained from a spot rate involve use of difference in interest rates of

two currencies to approximate the exchange rates of the future. The forward rate is then moved

up or down according to this interest rate differential so as to reflect whether the forward price is

correctly discounting or putting a premium on the currency or not. For instance, if in the foreign

exchange market there was a USD/EUR exchange rate of 1. price of 10 USD/EUR and the US

interest rate is higher than the Eurozone interest rate; the forward rate will be above the spot rate.

This adjustment eliminates arbitrage possibilities and establishes a fair price in the forward

market, which is crucial to prevent strangulating hedge costs due to changes in interest rates

(Chen & Liu, 2018). This methodology is especially useful for investors or corporate entities

seeking to enter value exchange contracts today at known exchange rates predicated upon the

current global interest rates. The process of calculating forward rates is in fact a sophisticated

process whereby fundamental mathematical equations are applied to the present spot rate

together with difference in interest rates and other variables like time to maturity and risk

premiums (Jorion, 2000). There are complex models used in work of financial institutions and to

traders who want, for example, to price forward trading of the currencies; the Fisher equation

and covered interest rate parity are those models used to derive forward rates properly (Baillie &

Myers, 1991). It is prone to incorporate market expectations and risk into the mean reversion

model, thereby assisting investors to make informed decisions on forward rates. Whether for

import/export or portfolio investing, business and individuals often rely on forward rates for risk

management in the global economy. Forward contract usage enables exporters and importers to

hedge against exchange rate risk to secure their profit and reduce the fluctuation influence on

their business models (Bonfiglioli et al. , 2018). Forward rates thus enable the multinational firm

to hedge its exposure to fluctuations in value in foreign countries while operating its business

and maintain stability in cash flows and financial performance (Shapiro, 2020).

1.3. Factors affecting forward premium/discount

There are several characteristics that determine if a currency trades forward against another at a

premium or a discount. The first one was established on the basis of interest rate differential

between the two currencies involved. But also changes in expectations related to future economic

conditions and policies of monetary authorities can importantly influence forward rates. For

instance, if there is higher expected inflation or interest rate change in one country, investors

may be willing to trade its currency at a forward discount Chinn & Frankel, 2019). Furthermore,

across the forward markets, liquidity risks may emerge and impact the prices of the forward

markets; in illiquid periods forward premiums or discounts may be larger as the costs that

characterize any transaction are high or because the market participants demand extra risk

premiums (Chen & Liu, 2018). Macro and geopolitical factors also have an important role; such

as political instability or macro economic shock leads to a big change in forward premiums or

discounts due to changes of views about risk level of concerned currencies (Darbyshire &

McIntyre, 2020). That is why it is important to reinforce the knowledge regarding these factors

in order to be able to predict the dynamic of forward exchange rates efficiently. In addition,

policymakers, especially central banks and governments, can move the forward rates through

imparting an effect on the interest rates and market sentiments (McCauley & Shu, 2018). Gross

Domestic Product, employment rates, balance of payments, also make contributions to the

perceived market and anticipated changes or movement of forward rates (Sarno & Taylor, 2001).

Additionally, changes in the expectation of the market, the volatility in the risk factor can create

a deviation in the forward rates which can be attributed to the changes in the market sentiment

and perception of the risk associated with the particular currency. (Chaboud et al. , 2014). Thus

the analyses presented above identifying these varied facets are important in grasping the

intricacies of the foreign exchange market and the forward contracts for such a market.

III. Risks and Limitations of Forwards

1.1. Counterparty credit risk and exposure

One of the major risks that relate to forward contracts regards counterparty credit, as this refers

to the risk that a specific counterparty may fail to meet its contractual obligations, and the

organization on the other side of the contract gets to experience certain losses. According to

Donnelly and Sheehy (2018), forward contracts include counterparty exposure that makes it

significant to evaluate and monitor the counterparty credit risk. It is especially crucial in OTC

markets where contracts are structured and non-standardized. The counterparty credit risk results

because forward contracts are over-the-counter, unlike the futures ones that are traded through

the exchange, which means the counterparty is exposed to the credit risk of its partner with

whom the forward contact has been made (Durham, 2021). He added that certain types based on

derivatives involve the counterparty credit risk, for example, when multinational corporations

fixing foreign exchange exposure by entering currency forward contracts. Another type of credit

risk that needs to be managed effectively involves counterparties, which can be addressed

through precautions like credit check, proper credit limits, and the use of collateral or netting

options to minimize losses (Eom & Park, 2020). Furthermore, macro factors potentially affect

counterparty credit risk by introducing changes in regulatory frameworks or through adjustments

of capital adequacy provisions or demands for central clearing of OTC derivatives. It is therefore

important for organizations to keenly observe changes to the regulatory environment with a view

to aligning their approaches to risk management accordingly to be on the safe side and shield

themselves from Counterparty Credit Risk. Furthermore, the development of technological

innovations like blockchain can address some of the challenges connected with counterparty

credit risk issues through change transparency and thorough deal registering (Gomber et al. ,

2018). Hence through the application of advanced technology and positive creed to counterparty

credit risk, they can control forward contract transaction risks and maintain the stability of the

transactions.

1.2. Lack of liquidity and flexibility

Lack of liquidity is, therefore, apparent; forward contracts also lack flexibility compared to other

derivatives; especially for emerging market instruments or exotic cross rates or commodities.

According to Duarte and Martins (2020), the above analysis of liquidity suggests that it

embodies features that make participants vulnerable to transaction cost risk, given that

constraints in this area lead to a rise in transaction costs and make it possible for players to enter

or exit positions at unwanted prices, also known as execution risk. In addition, the absence of

main and associated markets that are integrated and centralized as is the case in the futures

markets means that in the forward markets, positions cannot be easily unwound or adjusted prior

to maturity which narrows down the flexibility that may be exercised when adapting to particular

market conditions (Donnelly & Sheehy, 2018). This lack of liquid and flexibility becomes a real

concern since these are the very things that lack of which can hamper hedgers or investors who

require frequent changing of positions depending with the emerging market situations or

shocks. The authors in this research focused on two aspects of forward contracts, namely the

issue of customization and the problems with liquidity and flexibility in this form of trading, so

that market participants can understand that the need to integrate forward contracts in hedging

strategies or manage risk means holding an appropriate balance between downside risks and

benefits of trading in this form. They believe that the changes in regulatory frameworks and

progress in fintech can also be viewed as key factors that can provide potential solutions to the

issue of inefficiency of forward markets and lack of liquidity and flexibility. For instance,

improvements in regulations for the stock market that would make it easier for contracts to

become more standardized would in turn encourage more people and various organizations to

participate in the trading of the already existing securities, which leads to better securities market

liquidity (Gomber et al. , 2018). However, the integration of the e-trading system and the

utilization of algorithmic trading to enable the quick implementation of forward deals may

further improve the efficiency of the marketplace and address the present deficiencies in liquidity

and flexibility (Leinweber, 2019). In particular, through better awareness of relevant regulatory

changes, and through integrating and applying modern technology and techniques into its daily

practices, these market participants are generally much more capable of better management of

the liquidity and flexibility issues in forward markets.

1.3. Impact of market factors changes

Forward contacts are generally a function of a number of variables that are considered within the

context of the market that the particular deal is being set, including interest rates, exchange rates

as well as the price of specific commodities could greatly influence contract value as well as

contract compliance. Variations in interest rates, for instance, could result in either an increase or

a decrease of the forward premium or discount on currency forward contracts that may affect the

attractiveness of hedging activities (Froot & Thaler, 2018). Fluctuations of the exchange rate

present an opportunity for revaluation of the forward contracts and, hence, impact the net assets

or/and liabilities of hedgers and speculators or hedgers (Duarte & Martins, 2020). In the same

way, changes in the prices of commodities especially those in the forward markets significantly

affect the business of hedging or speculating in commodities (Eom & Park, 2020). Due to the

forward nature of these markets, it is only possible that participants in forward markets have to

convoy their analytical skills in monitoring the factors constantly. They have to reorient

themselves in their forward line and across their risk assessment mechanisms to counter the

uncertainties in the current market (Eberhart & Villareal, 2019). In the same way, macro factors

such as regulatory changes or shifts in market opinion can also affect the pricing of forward

contracts and its performance. (Donnelly and Sheehy 2018) It is, therefore, necessary to be

proactive in managing risks, as changes could have a negative consequences on business in the

long run. Additionally, there has been growth in the use of technology in both general and

particularly in financial sector and this has been a key factor in trading in forward contracts. That

means techniques such as algorithm trading and machine learning are looked at to identify

trading opportunities naturally known forward markets (Leinweber, 2019). With the help of such

technologies and utilizing stronger risk management measures, market actors may stabilize the

situation with forward contracts, and try to minimize the risk in order to receive more effective

experiences in trading, when circumstances are changing rapidly.

IV. Hedging Strategies with Forward Contracts

1.1. Hedging foreign currency exposure risks

Managing foreign currency exposure risks is an activity that is important in business and

investing in global markets so as to reduce the probability that a company or investor would

suffer a loss due to unfavorable currency fluctuations. Fukuda (2017) seeks to define hedging to

refer to the act of engaging in opposite trades in contracts with the aim of offsetting the effects of

fluctuating currency on cash or asset, often through forward contracts. For enterprises in

international business operating in the trading or investing overseas currencies hedging is a great

and important instrument controlling currency fluctuation for the foreign exchange prices

guaranteeing earnings and cash flow of the enterprise for future transaction, thereby diminishing

risks and volatility (Garcia & You, 2019). In the same way, those investors who have foreign

assets or liabilities can manage the fluctuations in currency through hedging possibilities in order

to reduce or control the erosive effects of depreciation or steep appreciation. In essence, the

organizations gain advantages by protecting themselves from currency fluctuations effects

because they can then focus on essential business and investment goals without having to worry

too much about nasty surprises in exchange rates (Ghosh & Wooldridge, 2021). To hedge

currencies, there are several elements that need to be considered ranging from the nature of

exposure and the time horizon, and general state of the market, together with the risk appetite or

tolerance levels of the organization. In the view of Hassan and Nath (2019), the following

procedures should be followed by the businesses so that they can have internal control to hedge

against exposures to foreign currency: This involves undertake a quantitative review of their

global operations, clients, suppliers and sources of funds; to measure the degree of exposure to

foreign currencies. After identifying exposures, it becomes easier for the companies to assess the

various hedging options in the market including but not limited to forward contracts, options,

swaps, or even natural hedges (Bekaert & Hodrick, 2020). There is no perfect hedging

instrument which is free from certain disadvantages but every hedging instrument has it own

merits and demerits based on the cost factors therein the flexibility that is provided therein and

most importantly the effectiveness of the hedging instrument within a given range of currency

risks.

1.2. Cross-currency hedging using forward contracts

Cross- Currency Hedging is the act of employing forward contracts that will help the firm to

hedge on currency exposure that has been derived from transactions done in one currency but

paid in another currency. As documented by Griffith and Winters (2022) forward contracts

remain popular for cross- currency hedging, helping businesses and investors in maintaining the

risk of currency movements related to trade, investment, or financing activities when working in

foreign countries. For instance, an American firm with revenues in euros may use forward

contracts to sell euros forward, thus bounding the future exchange rate between euros and US

dollars which would have suitable impacts from the current EUR/USD exchange rate when

translated in the future (Hansen & Sargent, 2020). Through forward contracts, hedge can be

crossed with the desired maturity date offering more customisation to meet with specific

exposure to currency and risk directions desired by corporations and investors (Heath & Roberts-

Sklar, 2019). Transaction cost can also be a important issue in cross currency hedging where

forward markets matter and a number of factors such as correlations between the two currencies

also matter. Firms may also consider other forms of hedging tools, including options or swap

structures based on a particular currency in an effort to meet its objectives of risk management

(Jorion, 2016). However, there are certain limitations to cross-currency hedging where the future

rates of exchange and the overall economic environment in which the currencies being hedged

operate in has to be predicted effectively (Kohonen & Kolehmainen, 2017). It’s for this reason

that companies using cross-currency hedging have to integrate reliable analytical tools and risk

management methodologies to determine and control their exposure values competently

(Lhabitant, 2019). However, certain restrictions and requirements have to be taken into account,

including the regulation of cross-currency hedging and the generally accepted accounting records

(Mackenzie, 2020).

1.3. Advantages and disadvantages of hedging

Managing currency exposure means addressing a complex risk factor and the experience of

APSC shows that this process requires careful step by step decision-making because potential

advantages may be offset by the probabilities of failure. Starting with establishing clear and

practical understanding regarding the nature and consequences of currency exposure in

transnational financial transactions, assets and liabilities is, thus, the initial and pivotal step

towards making sound decision. The evaluation of net cash flows, current and future earnings, as

well as balance sheets show the possible effects of fluctuation and assists in evaluating the extent

of risk and identifying proper measures for hedging this risk. Comparing the various derivatives

and strategies with cost of transactions and other aspects including liquidity and efficiency

makes it possible to identify the best technique for a given risk management plan. The following

are the most regularly used hedges: the forward contract; the options contract; and the currency

swap contract (Griffiths and Winters, 2022, pp. 301-302). Thus, before moving to the

implementation of the identified hedging program the clear goals and rules for its actions should

be defined as well as reviewed regularly and adjusted according to the modern trends in the

market. Though hedging has its benefits including, the flucuation that is inherent in assets values

and provides coverage against such flucuation then it also has its downside, it means that

incurring transaction cost and basis risk is inevitable and it therefore means that hedging

strategies must be properly evaluated after sometime and adjusted for major flaws that are

inherent in them (Hong & Wang, 2018). Furthermore, it is essential to realize the correlation

between currency-risk and other forms of risk including interest-rate risk and or commodity-

price risk so as to comprehensively manage risks that can affect the firm in its diversified distinct

aspects at once (Hau & Rey, 2021). Through these guidelines together with constant aversity to

market trends and other related factors, businesses and investor can manage the exposures to risk

associated with currencies while ensuring that their money is safe and equally trying to make the

most out of the opportunities which exist in the global markets.

V. Accounting and Regulatory Aspects

1.1. Accounting treatment of forward contracts

The execution of forward contracts holds a more triumphant part in providing the user of

accounting information the most accurate and unambiguous information in according to the IFRS

and the GAAP. Initial recognition: Derivatives, such as forward contracts, are initially

recognised at fair value in one balance sheet; Recognised or other adjustments of fair values are

recognised in the income statement from equation (6) (Hossain & Nguyen, 2020). It is a type of

approach which assists in determining the amount that these contracts are fairly reflected on the

balance sheet to facilitate provision of relevant information to stakeholders on the financial

position of the entity. The fair value of forward contracts must be determined from the market

data and the readily available market price; therefore, the enhancement of the clarity of financial

reporting could be attributed to such methods (Jiang & Lee, 2019). It also helps the entities to

avoid manipulating profits by using the accounting policies to hedge the accounts receivables

and other items that cyclical in nature. Hedging accounting allows to recognize the change in

value of the hedged item on the one hand, with the simultaneous change in the value of the

hedging instrument, on the other hand, hence, reduces matter that results from variability of

earnings as influenced by changes in fair value. However hedge accounting as the name

suggests involves a lot of documentation and effort to decipher the guidelines set by the

accounting standards to ensure that hedging relationship exists and that the financial statements

are reliable (Ito & Chinn, 2017). Though, the entity seeking to recognise hedge accounting in

order to smooth this earnings volatility must demonstrate the relative cost, benefits and effect of

hedging to the relevant accounting bodies and pass through various accounting

standards. Consequently, it can be stated that there is an essential role of the forward contracts

as the part of an entity’s risk managing strategies on the foreign exchange exposure, as well as

the proper accounting treatment for these contracts makes a significant contribution to the

disclosing process, the efficiency of the signalling, the accuracy of the financial reports, the

accountability of business undertakings and the proper working of the financial markets.

1.2. Regulatory requirements and compliance considerations

Legal standards and requirements are very useful elements often affecting the use of forward

contracts due to corporate and juridical issues relating to their application and implementation,

particularly for organizations operating in highly regulated industries and locations. These

regulations, as highlighted by Jain and Jain (2021), aims at improving the transparency and

accountability in Financial sectors through reporting and disclosure requirements pertaining to

Derivative instruments such as Forward Contracts. There can be some reporting requirements

that Entities may be required to report various aspects of their derivative activities such as; The

type of contracts used The notional amounts used in such contracts and The risks and exposures

faced in such contracts, as rightly pointed out by Jiang and Lee, (2019). Also, the new

regulations being implemented such as the ones in the US’ Dodd-Frank act come with extra

requirements like mandatory centralization and a reporting requirement for particular kinds of

contracts to strengthen the vigilance and regulation of risk in the market (Johnston & Markov,

2020). Compliance with the rules and regulations are critical not only in order to reduce the risk

of potential bad practices or market abuse but also to provide confidence and trust for the

investors in the financial markets as stated by Hossain and Nguyen (2020). Since compliance

promotes the increased integrity within the market which is vital for sustaining confidence and

the stability of markets as a mechanism for efficient capital allocation. Moreover, regulatory

frameworks are not static but rather, they are constantly emerging with time through changes in

risks within the market and through changes in the rules and regulations governing the market,

this makes it prudent that market participants should follow changes and new rules within the

markets to ensure they are in compliance with changes and new standards. The environment in

which derivatives operate is riddled with regulations and the management of the entity has to

ensure the derivatives business it undertakes conforms to the modern regulations set while at the

same time, conforming to all laid down regulations. Excellent corporate governance entails strict

policies and procedures to maintain accountability, established guidelines for managing business

risks, as well as ongoing communications with regulatory agencies on updates and changes to

laws and standards. Through commitment to compliance and recognition of regulations as an

important component of the risk management and governance architecture in financial markets

institutions, the desired goals of promoting the markets’ integrity, protecting investors and

enhancing sustainable growth of financial markets can be achieved as the institutions adapt to a

changing legal environment.

1.3. Tax implications of forward transactions

Benefits achieved through forward transactions have specified tax consequences, which mainly

depend on numerous factors such as jurisdictional differences and specific characteristics of

particular transaction. For instance, according to Hossain and Nguyen (2020), some of the factors

that may cause the treatment of gains or losses from forward contracts to differ include; the

nature of the transaction that the contract aims to fulfill, the time horizon that it would take to get

the contract’s fulfillment, or any difference in the tax status between the involved players. Piracy

and hedging transactions may be affected by a range of tax laws depending on the country’s

jurisdiction; these laws may include mark-to-market taxation rules or the custom-made tax rules

for hedging as highlighted by Jain and Jain (2021). In addition, Gross and Lee (2008) note that

tax legislation secures different tax rates and treatment of gains and losses, method of treatment

for corporate entities and individuals, in agreement with Jiang and Lee (2019). The arguments

continue to stand out more when cross-boundary transactions, which include forward contracts,

are factored in, as illustrated by Ito and Chinn (2017). Such transactions may pose some complex

aspects of taxation; transfer pricing complexity and withholding taxes are among the common

complexities. In light of the various interrelated complexities of taxes laid out above, it will be

advisable for entities to consult tax specialists and lawyers. Engaging with persons in these fields

ensures the acquisition of a broad perspective of the particular tax laws and procedures that

should be followed since doing business entails being in compliance with the various laws while

at the same time seeking to exploit the tax system to an organization’s advantage. Furthermore,

they noted that the present corporate tax laws prevent entities from totally managing currency

risk outside the existing tax system frameworks can therefore be managed by such collaborations

in a way that optimally improves the overall operations and financial performance of the

business.

VI. Alternative Instruments and Strategies

1.1. Futures contracts versus forward contracts

It may also be important to state that futures contracts as well as forward contracts are

derivatives applied for hedging as well as for speculative purposes, although they do have some

important differences. Futures contracts are exchange traded standardized products while

forward contract are non-standardized contracts negotiated between two counter parties in the

over the counter market. Indeed, it means that while futures are exchange traded standardized

products, forward contracts are non-standard exchange traded between two parties. As Moore

and Payne noted (2020), futures contracts are more liquid and transparent than forwards given

that they are traded through an exchange; this means that an investor can easily get into or exit

the contract without affecting market prices unlike what will happen in the forwards market. In

particular, there is more information homogeneity due to standardization: futures contracts are

uniformly specified by their size, expiry date, delivery terms, which promotes simplification of

operations and reduces market inefficiencies (Pan & Singleton, 2021). On the other hand,

forward contracts offer flexibility relating to the size, time of maturity, and terms of the contract,

though it might be subject to issues like limited availability of contracts and possibly requiring

negotiations between counterparties (Pan & Singleton, 2021). Moreover, forward contracts can

be adjusted to reflect the specific circumstances of both parties; this flexibility can effectively

manage risks and meet particular exposures or needs that may not be fulfilled in the course of

trading futures contracts (Moore & Payne, 2020). However, this led to high transaction costs and

counterparty credit risk because forward contracts do not offer the same risk protection

mechanics that are attained in futures contracts through clearing houses and daily margining, as

noted by Pericoli and Sbracia (2017). Therefore, companies involved in forward contracts have

to assess and manage credit risk of counterparties; often this is achieved by holding collateral or

conducting credit rating (Obstfeld & Rogoff, 2019). In the same way, futures and forward both

hold considerable importance in financial markets acting as methods for hedging, establishing

reference prices and speculation for various financial instruments and international markets.

1.2. Currency options as an alternative

Currency option is also a form of exchange rate contract which acts as the supplement to forward

contracts, allowing participants to have the ability to hedge their currencies in a rather flexible

manner while at the same time have the chance to make gains from any positive trends in

exchange rates. According to Olson and McCracken (2018), Currency options come with basic

provision that allows the holder the option, but not the requirement, to buy or sell a fixed amount

of currency at a fixed price known as strike price within a specific time known as expiry date of

the option. However, option arrangements involve a cost, paid up front as an initial payment by

an option holder, expressing his or her maximum potential loss. This characteristic increases the

opportunities to realize gains through differing exchange rates and at the same time, minimizes

the losses for each participant (Reitz & Taylor, 2017). Furthermore, options enable a range of

methods and allow for a variety of strategies such as: straddles strangles and spreads depending

on objectives and forecasts of the market (Ramamurti & Mukherjee, 2019). However, options

have their down sides, such as time value decay and, in default, could expire at nil worth

provided exchange rates do not unfold as estimated, hence they are thought to be more complex

and expensive than forward contracts (Ramos & Veiga, 2018). However, the above-discussed

complexities do not eliminate the importance of currency options, as they continue to serve as

practical tools for hedging risks related to fluctuating exchange rates and can be highly useful to

the entities that are looking for the optimal strategy in terms of both, the spreading of risks linked

to the fluctuations of specific currency pair as well as the chances to benefit from further

appreciation of the desired currency. Currency options are widely used by international

corporations actively participating in the buying and selling of goods and services, financial

institutions who provide currency option to their clients for hedging their risks, and lastly but not

the least, there are the speculators or currency traders who wish to make money out of foreign

exchange market . Furthermore, options makes it possible for companies and investors to

manage specific currency risks or portfolios, protect against event risk or a specific event that

potentially has drastic effects, or exploit the volatility in the currency markets in line with the

kind of trading strategies Chincarini & Kim (2018) discuss in their publication. However, it is

vital to comprehend the dynamics and uses of currency options in the execution of currency risk

management and in search of the right ways for managing financial risks internationally.

1.3. Combined strategies involving forwards derivatives

The use of forward contracts coupled with other derivative tools can vastly improve the

efficiency of risk management tools, leading to more currency hedging ability. According to the

authors Pericoli and Sbracia (2017), the possibility to incorporate forwards with options—called

collars or risk reversals—offers the opportunity of shielding against a declining currency while

benefitting from an appreciation in the same instrument. For example, a company using a

forward contract to hedge exposure to a particular currency may also simultaneously use a put

option to cap the exposure to any unfavourable movements in the exchange rates beyond an

agreed amount. Furthermore, forward contracts can be easily linked with futures prices or swaps

to develop complex hedging strategies in line with some specific risk management purpose

(including the Futures Prices and Swaps for constructing hedging strategies, Moore Payne,

2020). One may argue that these combined approaches are useful in enhancing the participants‘

ability to control risks, manage the costs of hedging and address different currency risks

,including transaction, translation and the economic risk (Jain & Jain, 2021). These types

of integrated strategies are particularly essential because changes in the AUD can have a huge

effect on the business’s financial performance. In particular, referring to MNEs incurring cash

flows and recognizing earnings in more than one jurisdiction, it may be said that combined forms

of hedge are also used. Moreover, the complex global financial Markets and regulations of

sensitive financial risks compel financial institutions to use complex derivatives for hedging

depending on the derivative product required by the institution (Manski, 2019). But, before going

further, it is crucial to note that, for developing a coherent integrated hedging strategies

approach, it is necessary to have a proper perception of instruments used in derivatives, risks,

and markets. Furthermore, the necessity of deep analysis and modeling can be explained by the

fact that evaluation of the efficiency and the cost of multiple hedge strategies and their

combinations is not an easy task. Altogether, the forward contract together with other derivative

tools provides the flexible and effective approach to solving the issues connected with the

currency risk in any kind of the enterprise activity.

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