FORWARD MARKETS AND CONTRACTS
FORWARD CONTRACTS
A forward contract is a contract between two parties in which one party agrees to buy and one party agrees to sell a particular asset at a particular date in future. Suppose today is June 13th and the two parties go into a contract, one party agrees to buy 1000 quintals of wheat at INR. 2000/ quintal on August 30th and one party agree to sell. The buying party is said to be LONG the forward contract and the selling party is said to be SHORT the forward contract. At the initiation of the contract there is no exchange of money. If the price of the asset increases over the time period before the expiration of the contract the long party wins otherwise the short wins. Considering the same example, suppose on July 10th the price of wheat becomes INR.2500 in the cash market. The long party wins because it has the right to buy a quintal of wheat at INR 2000 where as the current price for buying the same quintal of wheat is INR 2500. So the long party makes a profit of clean INR 500/ quintal or a total of 500*1000= INR 500000 and the short party makes a loss of the same amount. If the future price of the asset falls below the contract price( say INR 1500/ quintal), the result is opposite and the short party which has the right to sell at an above-market price( INR 2000/ quintal) makes a profit of INR 500*1000= INR 500000 in this case . The forward contract can be thought of as a simple bet between two parties in which one party expects the price of the asset to go up and the other party expects the price of the asset to go down.
More often FORWARD contracts are used by large companies to hedge their risk of buying or selling at a price which is uncertain. They want to lock in the price and reduce the risk (uncertainty). The other parties involved are speculators who want to earn profit on changes in prices and the arbitragers who earn when there are market inefficiencies.
Each party in a forward contract is exposed to default risk (or counterparty risk) as the forward contracts are over the counter contracts and are not backed by a clearing house. So there is a probability that the party which has lost the bet will not pay its obligations. This risk is absent in the case of futures contracts as these are highly standardized and are backed by a clearing house and both parties are required to deposit a margin money (typically 10% of the contract value).
Settlement Procedure:
Settlement can be done by:
· Delivering the asset
· Cash settlement
Consider the previous example in which the price of the quintal reaches INR 2500 on August 30th. The long party has the incentive to buy wheat at below market price (in this case the contract price i.e. INR 2000/ quintal) and sell at the market price (INR 2500/ quintal). This is one procedure for settling a forward contract at the settlement date or expiration date specified in the contract. An alternative settlement method is cash settlement. Under this method, the party that has a position with negative value is obligated to pay that amount to the other party. In the example, the short party can directly pay the difference between the contract price and the market price on the expiration date. In this case (2500-2000)/quintal * 1000 quintals= INR 500000. Ignoring transactions costs, this method yields the same result as asset delivery. On the expiration (or settlement) date of the contract, the long receives a payment if the price of the asset is above the agreed-upon (forward) price; the short receives a payment if the price of the asset is below the contract price. It can be seen as a zero sum game and can be visualised as a simple bet on the prices, the winnings of which will be decided by the price of the asset under consideration.
How to Terminate a Position Prior to Expiration
A party to a forward contract can terminate the position prior to expiration by entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract. Recall our example and assume that ten days after inception (June 23rd), the short, expecting the price to go even higher on the termination date wants to terminate the contract. Since the short is obliged to sell the asset only on August 30th it can effectively terminate the contract by entering in a long contract with the same expiration date as the short contract of the original forward contract i.e. entering into a forward agreement with expiration date August 30th and date of inception of contract June 23rd with a contract price of say INR 2200/ quintal. The position of the original short now is two-fold, an obligation to sell wheat at INR 2000/ quintal and an obligation to buy wheat at INR 2200/quintal. Thus he locks in a loss of INR 200/quintal*1000quintals=INR. After that he is effectively out of the Forward contract or has terminated the contract regardless of the market price of wheat at the settlement date. No matter what the price of a quintal of wheat 2 months from now, he has the contractual right and obligation to buy a thousand quintals at INR 2200/ quintal and an obligation to sell at INR 2000/quintal. However, if the short's new forward contract is with a different party than the first forward contract, some credit risk remains as the other party may not pay up the profit. An alternative is to enter into the second (offsetting) contract with the same party as the original contract. This would avoid credit risk since the short party can pay only the difference to the long party.
There are different types of forward rate contracts with various asset classes as their underlying. We will review each one separately including the pricing of each in the coming article. Just to give you an idea below is the list of different asset classes on which forward agreements are customised:
· Equity Indexes
· Zero coupon bonds
· Coupon bonds
· Floating rate bonds (LIBOR, EURIBOR, MIBOR)
· Currency exchange rates
Shubham Goel
IIM Rohtak
