Forward Contracts

Chapter 2
 Forwards
 Oldest of all derivatives
 A forward contract refers to an agreement
between two parties to
 Exchange (buy/sell) an agreed quantity of an asset
for cash
 At a certain date in future
 At a predetermined price specified in that
agreement.
 The promised asset may be currency, commodity,
instrument etc.
Forward Contract
 A user (holder) who promises to buy the
specified asset at an agreed price at a fixed
future date is said to be in “long position”.
 The user (holder) who promises to sell at an
agreed price at a future date is said to be in
“short position”.
 The mutually agreed price in a forward contract
is known as “delivery price”.
 The value of the contract is determined by the
market price of the underlying asset.
Features of Forward Contract
 The contract is usually referred to as FRC i:e forward
rate contract.
 OTC trading: These contracts are purely privately
arranged agreements and hence, they are not
standardized ones. they are traded OTC not in
exchanges. There is much flexibility: can be
modified according to the requirements of the
parties to the contract.
 No down payment
 Settlement on maturity
 Linearity: Symmetrical gains and losses due to price
fluctuation of the underlying asset
  When spot price > contract price the buyer is the
gainer
 Gain= spot price – contract price
 The gain which one get when the price moves in one
direction will be exactly equal to the loss when the
price moves in the other direction by the same
amount.
 No secondary market: Purely private contract
 Necessity of a third party: Intermediary may be a
financial institution like bank or any other third party
 Delivery: On the date of maturity of the contract.
Forward Price
 A forward price of a contract is the delivery price
which would render a zero value to the contract.
 Zero value implies that no party is required to
pay any amount to other when the contract is
entered into.
 When forward contracts are entered into forward
price and delivery price are identical.
 Gradually forward price changes and delivery
price remains unchanged.
PAY-OFF
 ST-spot price
 E= delivery price
 Pay-off for long position: ST- E
 ST>E ST=E ST<E
 gain break-even loss
 Pay-off for short position: E- ST
 ST>E ST=E ST<E
 loss break-even gain
Advantages of forward contract
 Forward contract can be used to hedge or lock in the
price of purchase or sell of commodity or financial asset
on the future commitment date.
 In forward contracts generally margins are not paid and
there is also no up-front premium(service charge), so it
does not involve service charge.
 Since forward are tailor made price risk exposure can be
hedge upto 100% which may not be possible in future
and options.
Disadvantages
 counter party risk is very much present in a forward
since there is no performance guarantee. On due date
the possibility of counter party failure to perform his
obligation creates another risk.
 It does not allow the investor to unwind the transaction
once it is entered into. At the most the contract can be
cancelled on the terms agreed upon by the counter
party.
 Since forwards are not exchange traded they have no
ready liquidity. Further it is difficult to set counter party on
one’s terms.
Pricing Forward Contracts
 Forwards are priced using “Cost of Carry
Model”
 Depending on the nature of the carry costs
associated with the asset and carry return
principle the model has been modified.
Carry Cost
 Carry cost include the holding costs for the
underlying assets. For commodities, this
may refer to warehousing costs, insurance
expenses, transportation cost, etc. For
financial products, carry costs include
financing cost like interest charges on
borrowing the cash to take position in the
asset.
Carry Return
 Carry return principle refers to the income
generated by the asset. For financial
product, carry return may include
dividends received on shares.
The major assumptions of the model
 Markets are perfect i:e.,information flow is
instantaneous and freely available, equal borrowing
and lending rates and large number of market
participants.
 The underlying asset are infinitely divisible.
 No transaction cost and brokerage fees
 Only one price exists thereby removing the
possibility of bid (buying rate)-ask (selling rate)
spread
 Absence of any market restrictions such as short
selling, margin money, etc.
Continuous Compounding
 The calculation of forward prices and
option prices is based on the concept of
continuous compounding
 A=P(1+r)n
 A= compounded value
 P=principal amount
 r=interest rate per annum
 n=time period
 A=P(1+ r/m)mn

 r= per annum rate of interest.

 m= number of compounding per
annum.
 n= number of years.
 For quarterly compounding m=4
 For daily compounding, m=365.
 A=Pe nr
 e is a mathematical constant whose
value is 2.7183
 r1=interest rate when m compounding
are done
 r2= equivalent rate when continuous
compounding is done
 (1+r1/m)mn=e r2n

 r2=m ln ( 1+ r1/m)

 r1= m (er2/m-1)
Three situations for pricing forwards
depending on underlying assets
 Asset with no income

 Asset providing a given amount of

income

 Asset providing a known yield

Asset with no income
 The prominent example of this type of
asset, giving no income, is an equity share
on non-dividend basis and a deep
discount bond.
 This is the simplest forward contract
 True price of a forward contract is that
when no arbitrage opportunities exist

 F=Ser*t
Asset providing a known cash
income
 The examples for assets, providing known
cash income, are bonds promising known
coupon rate, securities with a known
dividend, preference shares, etc.

 F=(S-I)*ert
Asset providing a known yield

 A known yield refers to income expressed as

percentage of the asset life, and this yield is
assumed to be paid continuously as a constant
annual rate of y

 In this case forward price is as follows:

 F=S*e (r-y)*t