What are Forward Contracts?
A forward contract is a customized contract between two parties to purchase or sell an underlying asset in time and at a price agreed today (known as the forward price).
- The buyer of the contract is called the long. The buyer is betting that the price will go up.
- The seller of the contract is called the short. The seller is betting that the price will go down.
- In this, no money changes hands until the settlement dateThe Settlement DateThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade.. In fact, the forward price is set so that neither party needs to pay any money at contract initiation.
- They are subject to default risk regardless of their methods of settlement. In both deliverable and cash-settled forward prices, only the party that owns the greater amount can default.
Value of forward Contract
At time t = 0, the long and the short agree that the short will deliver the asset to the long at time T for a price of F0 (T).
F0 (T) is the forward price. If at time T, the price of the underlying is ST, the long is obligated to pay F0 (T) to short.
Value of the contract to the Long at expiration = ST – F0 (T).
Value of the contract to the Short at expiration = F0 (T) – ST.
Settlement of forward Contract
When a forward contract expires, it can be settled in two ways:
#1 – Physical Delivery: In a physical delivery settlement, the long pay the agreed-upon price to the short and receives the underlying asset from the short.
#2 – Cash Settlement:Cash Settlement:Cash settlement is a settlement option frequently used in trading futures and options contracts, where the underlying assets are not physically delivered at the expiration date. At the same time, only the difference is paid by either of the parties, depending on the market rate. In cash settlement, the buyer (seller) receives the difference between the market price and the agreed-upon price if the market price is higher (lower) than the agreed-upon price on the date of settlement.
- Cash-settled contracts are more commonly used when delivery is impractical, e.g., in forward contracts on stock index, it would be impractical for short of delivering to the long a portfolio containing each of the stocks in the stock index proportionate to its weighting in the index.
- The cash-settled forward price is also known as non-deliverable forwards, i.e., NDFs.
How to Calculate Forward Prices in the Contract?
The pricing model used to calculate forward prices makes the following assumptions:
- No transaction costs or short-sale restrictions.
- Same tax rates on all net profits.
- Borrowing and lending at the risk-free rateRisk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk..
- Arbitrage opportunities are exploited as they arise.
For the development of a forward pricing model, we will use the following notation:
- T = time to maturity (in years) of the forward contract.
- S0 = underlying asset price today (t = 0).
- F0 = forward price today.
- r = continuously compoundedContinuously CompoundedThe continuous compounding formula depicts the interest received when constant compounding is done for an infinite number of periods. The four variables used for its computation are the principal amount, time, interest rate and the number of the compounding period. risk-free annual rate.
The forward price may be written as:
Forward Contract Formula #1
F0 = S0exp(rT)
The right-hand side of Equation 1 is the cost of borrowing funds to the underlying assetUnderlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates., and carrying it forward to time T. Equation 1 states that this cost must equal the forward price. If F0> S0.exp(rT), then arbitrageurs will profit by selling the forward and buying the asset with borrowed funds. If F0< S0.exp(rT), arbitrageurs will profit by selling the asset, lending out the proceeds, and buying the forward. Hence, equality in the formula must hold. Note that this model assumes perfect markets.
Suppose we have an asset currently worth $1,000. The current continuously compounded rate is 4% for all maturities. Calculate the price of a 6-month forward contract on this asset.
F0 = $l,OOO.exp(0.04*0.5) = $1,020.20.
Forward Contract Formula #2 (Forward Price with Carrying Costs)
If the underlying pay a known amount of cash over the life of the forward contract, a simple adjustment is made to Equation 1. Since the owner of the contract does not receive any of the cash flows from the underlying asset between contract origination and delivery, the present value of these cash flows must be deducted from the spot price when calculating the forward priceThe Forward PriceA forward price is the agreed-upon future price at which a supplier will deliver an underlying financial asset or commodity to a customer. It is entirely determined by the spot price of an underlying financial asset, which includes all carrying costs such as foregone costs, interest, and so on.. This is most easily seen when the underlying asset makes a periodic payment. We let/represent the present value of the cash flows over T years. Formula 1 then becomes:
F0 = (S0 – I) exp(rT)
Forward Contract Formula #3 (Effect of Known Dividend)
When the underlying asset for a forward contract pays a dividend, we assume that the dividend is paid continuously. Letting q represent the continuously compounded dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock. paid by the underlying asset expressed on a per annum basis, Formula 1 becomes:
F0 = S0 exp(r-q)T
Advantages of Forward Contracts
Some of the advantages are as follows:
- They can be matched with the exposure time period as well as with the exposure cash size.
- It provides a complete hedge.
- Over-the-counter products.
- Using forward products provides price protection.
- They are easy to understand.
Disadvantages of Forward Contracts
Some of the disadvantages are as follows:
- Capital binding is required. Before settlement, there are no intermediate cash flows.
- It is subject to default risk.
- Contracts can be difficult to cancel.
- Finding a counterparty may be difficult.
- Liquidity risk.
- Counterparty risk.
The parties engaged in forward contracts do not have the option to select the mode of settlement (i.e., delivery or cash-settled) on the settlement date; rather, it is negotiated between the parties at the start.
- Long gains if asset price higher than the forward price.
- Short gains if the asset price is less than the forward price.
- Neither party pays at contract initiation.
This has been a forward guide contract and its definition. Here we discuss how forward contract works along with an example and detailed explanation. We also discuss the advantages and disadvantages. You can learn more about accounting from the following articles –