Forwards : A Primer

By A.V. Vedpuriswar

Introduction

In many ways, forwards are the simplest and most easy to understand derivatves.

A forward contract obligates one party to buy and the other to sell a specific quantity of an asset, at a set price, on a specific date in the future.

Typically, neither party to the contract pays anything to

get into the contract.

The party to the forward contract that agrees to buy the financial or physical asset is called the long.

The party to the forward contract that agrees to sell or deliver the asset is called the short.

Underlying asset can be currencies, commodities, bonds, etc.

In equity forward contracts, the underlying asset is a single stock, a portfolio of stocks, or a stock index.

On expiration date, after delivery, the contract is terminated.

A few basics

Termination

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.

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.

The end user of a forward contract is typically a corporation, government unit, or non profit institution that has existing risk they wish to avoid by locking in the future price of an asset.

Dealers are often banks, but can also be nonbank financial institutions .

Ideally, dealers will balance their overall long positions with their overall short positions by entering into forward contracts with end users who have opposite risk exposures.

Players

A forward rate agreement (FRA) is a forward contract to borrow/lend money at a certain rate at some future date.

In practice, these contracts settle in cash, but no actual loan is made at the settlement date.

The long position in an FRA is the party that would borrow the money.

If the floating rate at contract expiration is above the rate specified in the forward agreement, the long will receive a compensation.

If the reference rate is below the contract rate, the short will receive a cash payment from the long.

Forward Rate Agreements

Problem

I expect to receive $1 million three months from now and enter into a cash settlement currency forward contract at Rs. 39.75/$. On the date of settlement, the actual exchange rate is Rs. 40.00/$. How will the cash settlement be done?

Solution

I will have to pay (40 – 39.75) (1,000,000)

= Rs. 250,000 to the counterparty

ProblemI have gone long on a currency forward contract for Euro 1 million at an exchange rate of $1.25/Euro. At settlement, the exchange rate is $1.24/Euro. What will be the cash settlement?

Solution

I have gone long on Euros.

The Euro has depreciated.

I gain.

So I will pay compensation

Compensation to be paid = (1.25 – 1.24) (1,000,000)

= $ 10,000

Problem

I enter into a forward contract for T bills with face value of $1 million and maturity of 90 days at a discount yield of 2.00%. What is the amount into which I have locked myself?

Solution

2.00% is for 1 year

For 90 days, the discount is 2 x 90/360 = 0.5% = 0.005

So settlement price = (1-.005) (1,00,000) =$995,000

ProblemAn FRA which expires in 30 days is based on a notional principal of $100,000 and 90 days LIBOR. The rate quoted is 4%. The actual rate 30 days from now is 5%. What is the cash settlement at expiration?

Solution

Compensation to the long = (.05 - .04) x 90/360 (100,000)

= $ 250

But this compensation will apply at the end of the loan period.

Discounted value = 250/[1+(.05)(90/360)]

= $246.91

Problem

Consider a $1 million FRA with a contract rate of 5% on 60 day LIBOR. If the 60 day LIBOR is 6% at settlement, how much will the long receive?

Solution

Compensation = (1,000,000) (0.06 -0 .05) (60/360)

= 1,667 at the end of the loan period

= 1667 / [1 + (0.06) (60/360)] = 1650

at the expiration of the FRA

Ans: $ 1650