- Slides: 11
Forward Contract Rashedul Hasan
forward A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. 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 • The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. • The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.
forward Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
Futures versus forwards While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects: • Futures are always traded on an exchange, whereas forwards always trade over-thecounter, or can simply be a signed contract between two parties. • Thus futures are standardized and face an exchange, while forwards are customized and face a non-exchange counterparty.
Futures versus forwards • Futures are margined, while forwards are not. • Thus futures have significantly less credit risk, and have different funding. • In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.
How a forward contract works • Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100, 000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104, 000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.
How a forward contract works At the end of one year, suppose that the current market valuation of Andy's house is $110, 000. Then, because Andy is obliged to sell to Bob for only $104, 000, Bob will make a profit of $6, 000. To see why this is so, one needs only to recognize that Bob can buy from Andy for $104, 000 and immediately sell to the market for $110, 000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6, 000, and an actual profit of $4, 000.
How a forward contract works The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time.
How a forward contract works As the exchange rate between U. S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened as the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so even though they may not truly need Canadian dollars and are simply hedging currency risk, but they are speculating on the currency, expecting the exchange rate to move favorably in order to generate a gain on closing the contract.
How a forward contract works In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114. 4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less that amount, which refers to the leverage created, which is typical in derivative (finance) contracts.