FORWARDS CONTRACTS

Unit Structure 3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 Overview Learning Outcomes What is a Forward Contract? Examples/Scenarios Payoff Profiles Forward Options and Swaps Pricing of Forwards Summary Activities References & Readings

3.0

OVERVIEW

This unit focuses on the oldest derivative asset, namely a forward contract. It starts by defining such contract and discusses the other family on such contract namely forward options and forward swaps. Applications of such contracts are demonstrated together with its pricing.

3.1

LEARNING OUTCOMES

By the end of this unit, you should be able to do the following: 1. 2. 3.
Unit 3

Define a standard forward contract and also other types of forwards commonly known as forward options and forward swaps. Analyse the use of such contracts in managing risks. Derive the pricing of forwards.

1

which in turn agrees to pay the farmer a specified price for the grain upon delivery. at a specified future date. if a foreign currency stands at a discount in the forward market. If a foreign currency stands at premium in the forward market. it shows that the currency is ‘stronger’ than the home currency in that forward market. It is a contract/an agreement between two parties. 3. The words stronger and weaker are put in inverted commas Unit 3 2 . at planting time. agreeing to sell the underlying asset. However.4. it shows that the currency is ‘weaker’ than the home currency in that forward market. without the involvement of a third party or an organised exchange. the majority of forward trades in terms of value take place among large financial institutions and corporations. The other party assumes a short position. The essential reason for the trading of forward contracts is that it allows both buyers and sellers to remove any uncertainty over the future price at which they must purchase/sell a given commodity. Forward contracts are settled by delivery on the delivery date. one party assumes a long position. By contrast. agrees to deliver a specified quantity of grain at harvest time to a grain elevator. Forward contracts are said to be traded over-the-counter. at a specified price.2 WHAT IS A FORWARD CONTRACT? The forward contract is the simplest and oldest derivative asset. that is. The date on which the exchange is to take place is called the delivery date and the price for which the asset will be exchanged is called the delivery price. a buyer and a seller to exchange a specified financial asset (or quantity of a commodity). It should be noted that forward contract are available for both amount payable (example when requiring foreign currencies to import) and for amount receivables as well (example when exporting goods and services and expecting payment in foreign currencies). In a forward contract. An example of a forward contract is when a farmer. Draw payoff profiles of long and short positions. agreeing to buy the underlying asset. Forward contracts are common among firms of all sizes that have long-standing working relationships.

50. the bank would be a loser if the spot exchange rate at the time the American firm repaid the loan was less than $1.55 = $15.5m. a company based in the US knows that it will pay ₤10m on December 16. without taking any other action. in general one of the two parties will gain and one lose through the forward contract. Unit 3 3 . 3. 2007 for goods it has purchased from a British firm. The amount to be paid in US dollars at on December 16. However.3 EXAMPLES/SCENARIOS Example 1 Consider a British bank which lends an American firm $3. 2006 is ₤10mX1.55 (US dollars).300 at a rate of one pound sterling for $1. this would be impossible. firm A. The firm has therefore hedged against exchange rate volatility. Suppose the agreement is to buy ₤1 for $1. it will have a cashflow of $3. assuming the firm does not default. Example 2 Suppose that it is August 16 2007 and. Firm A can buy pounds from a bank in a four-month forward contract and thus hedge against foreign exchange risk. it would like to lock in the value of this cashflow in sterling. In terms of the example given above. as a British institution. strength and weakness merely take account of interest rate differentials as suggested by interest rate parity. The buyer loses if the price specified in the forward contract exceeds the price being charged in the spot market for the item in the question.50 per pound sterling.000 with repayment of the loan to take place in one year and dollar interest charged at 10 per cent. therefore.200.because. The bank knows that. The risk of exchange rate movements implies that. in the context of forward markets. The bank. while the seller loses if the converse is true. This fixes the bank’s cashflow from this project at £2. enters into a one-year forward contract. in which it agrees to sell $3.300 in one year. Note that at the time when the transaction actually occurs.

Example 4 Consider a Mexican exporter who expects to receive €100 million in six months. Unit 3 4 . The derivatives contract protects against this potential loss: the manufacturer receives €10 million from the bank in November 2008. Therefore.18. the market value of the forward contract must be zero when initiated since otherwise the exporter would get something for nothing. the exporter locks in the current forward rate (if the forward rate is $1. Since no money changes hands when the exporter buys euros forward. In our example.50 per euro to his bank in November 2008. the financial position is a forward contract. as originally agreed. for the US$15 million. €1 equals US$1. the exporter receives $118 million at maturity). This means that firm would have to pay ₤10mX3=$30m if it did not hedge again the exchange rate risk. Example 3 A European manufacturer sells solar modules to a New York utility company for US$15 million. despite the dollar’s severe depreciation. the US$15 million will only be worth €7. Financial hedging involves taking a financial position to reduce one’s exposure or sensitivity to a risk. the exporter loses $12 million. If the price of the euro falls by 10 percent over the next six months. the exposure is €100 million in six months.Suppose that on 16 November 2007 the exchange rate is ₤1=$3. and the exposure to the euro is perfectly hedged with the forward contract. In January. The sale is agreed in January 2008 with delivery and payment scheduled for November 2008. the risk is the euro. so the contract is worth €10 million. so it is important that he protects himself against a fall in the US dollar relative to the euro.50. he enters into a derivative contract on the US dollar with his bank as the counterparty.5 million to the manufacturer. If the US dollar falls to US$2 per euro by November 2008. By selling euros forward. The contract gives him the obligation to sell US$15 million at an exchange rate of US$1. The manufacturer pays his material and labour costs in euros. hedging is perfect when all exposure to the risk is eliminated through the financial position. Suppose that the price of the euro is $1.20 now.

If ST < K.4 PAYOFF PROFILES The payoff from a forward contract at delivery will depend on the spot price of the asset on the delivery date. are illustrated in Figure below. The payoffs from long and short forward positions at delivery. The payoff at delivery from a short forward position is the exact opposite of that from a long position. the price at which the asset can be purchased or sold for immediate delivery on that date.ST . In general. the payoff at delivery from a long forward position is ST . the payoff from a short forward position is K .K: if ST > K. In general. Unit 3 5 . the long investor gains because he is entitled to purchase an asset that is worth ST at a lower price K. that is.3. as functions of the spot price on the delivery date ST and the delivery price K. the long investor loses because he is obligated to purchase an asset that is worth ST at a higher price K.

88 7/8 – 7. Consider the following example Adapted from Buckley (2004) Chapter 13.83 1/8 – 7.87 3/8 7.90 7.84 5/8 7.93 ½ 3 7/8 – 3 ½ cpm 6 ¾ . page 214 Contract data Seller Buyer Contract date Credit term Expected payment date Invoice value UK exporter French importer 1 May 2005 3 months 31 July 2005 EURO 5m Exchange rates quotes at 1 May 2005 Spot 1 month forward 2 months forward 3 months forward 4 months forward 7.92 ¾ .5 FORWARD OPTIONS AND SWAP DEALS Forward options and swaps are best explained through an illustrative example.92 ¾ .11 5/8 cpm Outright exchange rates quotes at 1 may 1995 Spot 1 month forward 2 months forward 3 months forward 4 months forward 7.7.93 ½ 7.7.80 7/8 – 7.86 – 7.81 1/8 Unit 3 6 .3.6 1/8 cpm 9 5/8 – 8 7/8 cpm 12 ½ .

Unit 3 7 . However. a trader cannot be certain when one will pay a bill as the counter party may do so before the due date or may pay afterwards.755 Indeed in the reality of business world. the exchange rate is irrevocably fixed when the contract is made. The rate to the seller of EURO is the full two months’ discount. This is the worst rate between month 2 and month 4 for selling EUROS. assume that the UK exporter expects payment between 30 June and 31 August 2005. Thus from the previous scenario. Forward Options Indeed the British exporter may decide to cover despite an uncertain payment date via a forward option (probably because the delivery date may be uncertain as well). that is. the forward option is over the third and fourth months. Coming to our numerical example.84 5/8 equals £1 For EURO 5m he receives £637. the precise maturity date is left open and it is for the firm to decide subsequently. it is assumed that the French customer would pay on 31 July 2005. Indeed like all forward contracts.84 5/8 UK exporter receives EURO 5m from French importer UK exporter delivers EURO 5m and receives sterling at the rate of EURO 7. However in a forward option contract.Mechanism of forward contract 1 May 2005 31 July 2005 UK exporter sells EURO 5m forward 3 months at 7.that is between two and four months from invoice date. In the example of the above figure. three months after invoice date. it may also happen that the French purchaser decides to pay on some uncertain date between 30 June and 31 August 2005. The bank charges its customer the worst rate during the option period.

In either case. Swap deals used for forward cover are of two types: forward/forward and spot/forward. probably because the delivery date is equally uncertain. Swap Deals Another method of dealing with unspecified settlement is a swap deal. the exporter begins by covering the foreign currency transaction forward to an arbitrarily selected but fixed date.It should be clearly understood that the forward option contract is not a currency option (discussed later on). the forward cover may be extended by a spot/forward swap. the original settlement date may be extended to the exact date by a forward/forward swap. In fact if an exact settlement date is not agreed by the date when the initial forward contract matures. simultaneously entered into but for different maturities”. or forward swap. He or she does buy EURO 5m forward for delivery on 30 June (‘contract of the original forward sale of EURO) Unit 3 8 . The British exporter takes out a forward contract on 1 May 2005 (the date of the sale contract). The forward option is optional in terms of the date of delivery – currency must be delivered under the contract. The British exporter thus needs to counter the original forward sale of EUROS for settlement on 30 June and replace it with a contract for delivery on 31 July. he or she sells EURO 5m forward for delivery on 30 June 2005. “A forward/forward swap. A swap involves the simultaneous buying and selling of a currency for different maturities. just as in an ordinary fixed-date forward contract. the UK exporter and French purchaser agree that settlement will take place on 31 July 2005. however let us assume that the expected settlement date is uncertain. This method is most of the time cheaper than covering by way of forward options. Therefore. Then if the precise settlement date is subsequently agreed before the initial forward contract matures. is merely a pair of forward exchange contracts involving a forward purchase and a forward sale of a currency. Bukley (2004) Assume that the details of an export contract from Britain to France as per contract above. Now let us suppose that on 20 June 2005. This forward contract is for an arbitrary period of 2 months.

87⅜ (delivery 30 June 2005) 20 June 2005 Buy EURO 5m for £ forward 10 days At 7. one of which is a spot contract while the other is a forward contract. Unit 3 9 . The second and third transactions are the opposite sides of the forward swap.9425-7.95 7.9575 7.9550 7. The effect of the above forward swap is that the British exporter has locked in as of 1 May 2005 at the forward rate for two months’ cover adjusted for the premium/discount for a further month given by the bid/offer spread offer incurred on the forward/forward swap.141 (629. It again involves a simultaneous pair of foreign exchange contracts.9475-7. thereby extending delivery to 31 July.9450-7. the bank gives the UK exporter the following quotes Spot 10 days forward 1 month forward 41 days forward 7.9425(delivery 30 June 2005) 20 June 2005 Sell EURO 5m for £ forward 41 days At 7. Let us further assume that on 20 June 2005. A spot/forward swap is similar to a forward swap.and simultaneously selling EURO 5 cm forward 41 days.96 (delivery 31 July 2005) Net sterling proceeds 633.637 628. the overall mechanism reverses the first one. in the second transaction.021 As can be seen from the above.94-7.525) 635.9600 Here below is a summary of transactions and the net payment/receive: 1 May 2005 Sell EURO 5m for £ forward 2 months At 7.

the forward/forward or spot/forward swap is the preferred method of dealing with a continuing stream of foreign currency payments or receipts.Activity 1 Attempt a spot/forward swap from the above example. In this section. Although the large number of small exports would normally have different settlement dates. 2004 for treatment of similar problem. This problem may be overcome by taking out a single. we present a short note on continuous compounding. 3. it is expensive both in transaction and administrative costs to cover each individual deal. forward options are ideally suited to this kind of situation. In practice. Before getting into pricing issues however. Refer to Buckley. we shall see how an institution (usually a merchant bank) prices these assets. The underlying principle which will be employed in pricing is absence of arbitrage. Where a firm’s sales include a large number of small transactions denominated in foreign currency terms. large forward option contract to cover the approximate expected total cash value of the large number of different receivables or payables.6 PRICING OF FORWARDS The section above provided an introduction to the most common (but by no means the only) derivative assets which are traded. Unit 3 10 .

Continuous Compounding Recall from your basic finance courses. if the compounding occurs k times per year (still at annual rate r) the terminal value is: r X (1 + ) k k This is known as discrete compounding. risk-free asset. The pricing of currency forwards is based on the covered interest parity and is derived as follows. Similarly. They have two alternative investment strategies. Pricing Currency forwards The price of a currency forward is: F = S e(r-rf)(T-t) f S r rf t = forward rate = = = = spot rate rate of interest in the domestic economy rate o interst in foreign economy time Assume r is the domestic rate and r f is the foreign interest rate. Assume an amount X is invested for a single year at rate r per annum. the terminal value will be computed. Investment of Unit 3 11 . no matter how large it may be. Consider an investor who currently has $1. for example France. the terminal value of the investment is X (1+r). If compounding occurs once a year. that is since k is a known figure. investment in the domestic risk-free asset and investment in the foreign. Continuous compounding involves allowing the number of compounding dates within a year to tend to infinity and under this assumption the expression tends to Xern.

Unit 3 12 . The exchange rate is quoted as the domestic price of a unit of foreign currency. the investor sells the known proceeds forward at forward rate F. it must be the case that the dollar proceeds from a riskfree US investment equal those from a risk free French investment. the investor must first exchange his dollar for yen at the spot exchange (S). the dollar receipts from the foreign investments are: F erf(T-t) S Note that every interest rate and exchange rate used in both the above calculations are known at the present rate. To invest at the foreign rate. hence the $1 translates to EURO S-1. as given above.the dollar at the domestic rate yields a terminal value of e r (T. In equilibrium. Thus. This is then invested at the foreign rate yielding a terminal value of: 1 erf(T-t) S Finally. hence the forward must be set such that: F erf(T-t) =er(T-t) S Which implies that. t. to lock in the dollar receipts from the foreign investment. the equilibrium forward exchange rate is: F=Se(r-rf)(T-t) The formula tells us that the forward exchange rate differs from the spot exchange rate by a factor which is determined by the interest rate differential between the respective countries.t).

3. Unit 3 13 . investors can use these contracts to tie down the domestic currency value of a foreign currency cash-flow to be received at a future date. • The payoff from a forward contract at delivery will depend on the spot price of the asset on the delivery date. the forward price is the current spot price (S) continuously compounded over the life of the forward contract).t) (I. at a specified future date. As in the derivation of the forward price. a buyer and a seller to exchange a specified financial asset (or quantity of a commodity).Currency forwards (and futures) are widely employed as instruments to remove foreign exchange risk. the price at which the asset can be purchased or sold for immediate delivery on that date.7 • SUMMARY The forward contract is the simplest and oldest derivative asset.e. It is a contract/an agreement between two parties. the forward price implied by absence of arbitrage argument is as follows: F = Se r (T. that is. at a specified price. • The essential reason for the trading of forward contracts is that it allows both buyers and sellers to remove any uncertainty over the future price at which they must purchase/sell a given commodity. Pricing forward contracts (other than foreign currency) In fact.

Swap deals used for forward cover are of two types: forward/forward and spot/forward. • Forward exchange rate differs from the spot exchange rate by a factor which is determined by the interest rate differential between the respective countries. the precise maturity date is left open and it is for the firm to decide subsequently. This method is most of the time cheaper than covering by way of forward options.• In a forward option contract. Unit 3 14 . A swap involves the simultaneous buying and selling of a currency for different maturities. • Another method of dealing with unspecified settlement is a swap deal.

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