As India integrates more deeply into global trade, companies are becoming increasingly vulnerable to foreign currency risk, where even minor exchange rate fluctuations can have a significant impact on profitability, cash flows, and asset values.
To manage this risk, Indian businesses commonly rely on forward contracts as a key tool in their foreign exchange hedging strategy. In this article, you will discover what forward contracts are, how they function, and how they are accounted for under Indian standards.
1. Foreign Exchange Hedging – An Overview
Foreign exchange hedging is the practice of reducing the risk that currency fluctuations will affect the value of foreign currency receivables, payables, loans, or investments.
For Indian entities, this is especially relevant in cases such as:
• Exporters receiving payments in foreign currency.
• Importers making purchases in foreign currency.
• Borrowers with foreign currency loans.
• Investors in overseas subsidiaries.
Example:
Suppose an Indian exporter expects to receive USD 5,00,000 in three months. If the rupee strengthens during this time, the exporter will receive fewer rupees for the same dollars. By using a hedge, the exporter can lock in today’s exchange rate and ensure predictable cash flows.
2. Forward Contracts – The Hedging Tool
A forward contract is a customised agreement between a business and a bank or authorised dealer to buy or sell a fixed amount of foreign currency at a pre-agreed rate on a specified future date.
Key points for Indian entities:
• Entered into through authorised dealers, in line with RBI guidelines.
• The tenure typically matches the underlying exposure.
• No upfront premium is payable (unlike options).
• Both parties are legally bound to complete the transaction at maturity.
3. Benefits
• Locks in the exchange rate to remove uncertainty.
• Can be customised for specific amounts and maturity dates.
• Requires no upfront cash outflow.
Drawbacks:
• You’ll gain if the exchange rate moves in your favour.
• There is potential counterparty credit risk (though minimal when dealing with banks).
• Cancelling the contract before maturity may lead to additional costs.
4. Accounting Treatment in India
The accounting treatment varies depending on whether a company follows Indian Accounting Standards (Ind AS) or the older Accounting Standards (AS).
4.1 Under Ind AS (Ind AS 109 & Ind AS 21)
(a) Initial recognition:
• At inception, forward contracts are recorded at fair value, which is usually nil if no premium is paid.
• The entity must document the hedge relationship along with the related risk management objective.
(b) Subsequent measurement:
• Cash flow hedge: Changes in fair value are recorded in Other Comprehensive Income (OCI) and later transferred to profit or loss when the hedged item affects earnings.
• Fair value hedge: Changes in the fair value of both the hedged item and the hedging instrument are recognised in profit or loss.
• Speculative contracts: The entire change in fair value is recognised in profit or loss immediately.
(c) On settlement:
The gain or loss on the forward contract is recognised, and the related receivable or payable is recorded at the prevailing spot rate.
4.2 Under AS 11 (Indian GAAP)
• Forward contracts entered into for hedging purposes are recorded either at the forward rate, or at the spot rate adjusted for the forward premium/discount, which is amortised over the life of the contract.
• Exchange differences are recognised in the Statement of Profit and Loss in the period in which they arise.
• If the contracts are used for trading or speculation, mark-to-market gains or losses are recognised immediately in the Statement of Profit and Loss.
Illustrative Example – AS 11
Case:
An importer has a payable of USD 1,00,000 due in three months. The current spot rate is ₹84.00, and the three-month forward rate is ₹84.50.
At inception:
If no premium is paid upfront, no accounting entry is required. The forward premium (₹0.50 × 1,00,000 = ₹50,000) should be amortised over the three-month period.
At settlement:
If the actual spot rate is ₹85.00, record the exchange difference and adjust the payable based on the contracted forward rate.
5. Disclosures for Indian Companies
Under Ind AS and AS 11, entities are required to disclose:
• The nature and purpose of forward contracts.
• Outstanding positions along with their fair values.
• The company’s risk management policies.
• Gains and losses recognised in P&L and OCI.
6. Key Takeaways
For Indian businesses, forward contracts are among the most practical tools to hedge foreign exchange risk. They offer certainty, but also impose strict obligations.
Good practices:
• Align forward contracts closely with the underlying exposures.
• Adhere to RBI’s approved hedging framework.
• Maintain comprehensive documentation to support hedge accounting.
• Apply the correct accounting treatment under AS 11 or Ind AS 109/21.
By combining effective hedging strategies with accurate accounting, Indian businesses can safeguard profitability against currency volatility while ensuring compliance. Ultimately, a disciplined approach to risk management not only protects your financial position but also builds long-term resilience in an unpredictable global market.