Forward Contract - Introduction

IBA - Ravi

Forward Contract

• A Forward contract is an agreement to buy or sell an underlying asset for a predestined quantity, at a predetermined price after a predetermined period.

• The party with an obligation to buy is known as the long party as they hold the long position.

• The party with an obligation to sell is known as the short party, as they hold the short position.

Forward Contract• The guaranteed price is the delivery price or contract price

and the date on which the sale will transpire is the delivery date.

• The key benefit of a forward is the mitigation of uncertainty; both buyer and seller lock in a price that does not change.

• A distinguished characteristic of the forward is the bestowal of obligation.

• No matter what the spot price of the underlier come delivery date, the long party must buy and the short party must sell.

Forward Contract contd.

• Forwards are bilateral over-the-counter (OTC) transactions, and at least one of the parties involved is normally a financial institution. OTC deals are used by corporations, traders and investing institutions.

• Forwards potentially involve counterparty risk – the risk that the other party may default on its contractual obligations.

Forward contract contd.

• In a physically delivered forward contract one party agrees to buy and the other to sell a commodity such as oil or a financial asset such as a share: on a specific date in the future; at a fixed price that is agreed at the outset.

• Some contracts are cash-settled. • This means that one party pays the other the

difference between the fixed price stated in the contract and the actual market value of the underlying commodity or asset on a future date.

• The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

• The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Forward Contract Illustration• A example would help illustrate the mechanics of a forward

contract. Suppose on January 1, 2012 an Indian textile exporter receives an order to supply his product to a big retail chain in the US. Spot price of INR/US exchange rate is Rs. 45/dollar.

• After six months, the exporter will receive $1 million (Rs 4.5 crore) for his products.

• Since all his expenditure is in rupee term therefore he is exposed to currency risk.

• Let’s assume that his cost of production is Rs. 4 crore. To avoid uncertainty, the exporter enters into a six-month forward contract with a bank (with some fees) at Rs. 45 to a dollar. So the exporter is hedged completely.

Forward Contract Illustration• If exchange rate appreciates to Rs. 35 after six months,

then the exporter will receive Rs. 3.5 crore after converting his $1 million and the rest Rs. 1 crore will be provided by the bank.

• If exchange rate depreciates to Rs. 60/dollar then the exporter will receive Rs. 6 crore after conversion, but has to pay Rs. 1.5 crore to the bank.

• So no matter what the situation, the exporter will end up with Rs. 4.5 crore.

• The only risk exporter faces is counterparty risk (what if the bank or the retail chain goes bankrupt).

'Forward Price'

• The predetermined delivery price for an underlying commodity, currency or financial asset decided upon by the long (the buyer) and the short (the seller) to be paid at predetermined date in the future.

'Forward Price'

• Taking positions in a forward contract is a zero-sum game.

• For example, if Joe takes a long position in a pork belly forward agreement and Jane takes a short position in a forward agreement, any gains that Joe makes in the long position equal the losses that Jane incurs from the short position.

• By initially setting the value of the contract's value to zero, both parties are on equal ground at inception of the contract.

EQUITY FORWARD CONTRACT • Suppose that a trader agrees today to buy a share in a year’s

time at a fixed price of $100. This is a forward purchase, also called a long forward position.

• For example, if the share is worth $150 in a year then the trader buys it for $100 through the forward contract and can sell it immediately for a $50 profit. However, if the share is only worth $50 the trader is still obliged to buy it for $100. The loss then is $50.

• The other party to the deal – the counterparty – has agreed to sell the share to the trader in a year for a fixed $100 price. This is a forward sale, also called a short forward position.

FOREIGN EXCHANGE FORWARDS

• A spot foreign exchange (FX) deal is an agreement between two parties to exchange two currencies at a fixed rate in (normally) two business days’ time.

• The notable exception is for deals involving the US dollar and the Canadian dollar, in which case the spot date is one business day after the trade has been agreed.

• The day when the two currencies are actually exchanged is called the value date. A spot deal is said to be ‘for value spot’.

Outright Fex deal

• An outright forward foreign exchange deal is: • a firm and binding commitment between two parties;

• to exchange two currencies;• at an agreed rate; • on a future value date that is later than spot• The two currencies are not actually exchanged

until the value date is reached, but the rate is agreed on the trade date.

Outright Fex deal• Outright forwards are used extensively by companies that have

to make payments or are due to receive cash flows in foreign currencies on future dates. A company can agree a forward deal with a bank and lock into a known foreign exchange rate, thus eliminating the risk of losses resulting from adverse exchange rate fluctuations.

• The other side of the coin, of course, is that the contract must be honoured even if the company could subsequently obtain a better rate in the spot market.

• In effect the company surrenders any potential gains resulting from favourable movements in currency exchange rates in return for certainty

Forward contracts

• A forward contract is traded in the over-the-counter market—usually between two financial institutions or between a financial institution and one of its clients.

Forward contracts

• One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.

• The other party assumes a short position and agrees to sell the asset on the same date for the same price.

Forward contracts

• Forward contracts on foreign exchange are very popular, and can be used to hedge foreign currency risk.

Forward Contract Payoff

Payoffs from forward contracts

• The payoff from a long position in a forward contract on one unit of an asset is

S - K• The payoff from a short position in a forward

contract on one unit of an asset isK - S