What are Forward Contracts?

A forward contract is an agreement to buy or sell an underlying asset, such as gold or an index basket of stocks, at a specified date in the future.

A forward contract is a private, over-the-counter contract between two parties; it is not exchange traded. Alternatively a futures contract is exchange traded and the parties post margin upon contract initiation.  More on the differences between forwards and futures will be discussed throughout the module.

A forward contract can be customized to meet the specific needs of the two parties.

Since a forward is over the counter, it can be difficult to exit the position prior to expiration.  The party with negative contract value can attempt to buy out the other contract party or one party can attempt to sell his/her position to a third party.

Forward Contract Price and Forward Contract Value

Forward Contract Price: The set price or interest rate agreed to at contract initiation that will be paid by the forward buyer upon expiration, at the agreed settlement date.

  • The buyer of the contract is in the long position and will purchase the underlying asset at the contract price and the seller is in the short position and must deliver the underlying asset to the contract buyer.
  • The forward contract price set at initiation is based upon an arbitrage relationship between the contract and the underlying asset; this arbitrage relationship causes the forward contract’s value to equal zero at initiation.
  • Arbitrage Relationship: based on the sequence where the underlying asset is purchased with borrowed capital at the risk free rate and the forward contract is sold (note that adjustments will be made for cash inflows and outflows

    associated with the underlying during the contract term). The arbitrage transaction is made with funds borrowed at the risk free rate, so the accurate forward price assumes that no profit will be made and the value at contract initiation is zero.

  • A forward contract is priced at initiation and the price is set at an amount that is theoretically fair to both the buyer and seller.

Forward Contract Value: This is the amount required to assume ownership of an existing forward contract.

  • The value of a forward contract upon initiation is zero as a result of the arbitrage relationship between the contract and the underlying asset.
  • A forward contract can be valued at any time during the life of the contract.
  • A forward contract price is set at initiation and will not change regardless of market movements; alternatively, the forward contract’s value will most likely change from its initial value of zero between initiation and settlement as market conditions change.
  • Forward Contract Value at Expiration = Price of the Underlying Asset at Expiration less the Forward Contract’s Price at Initiation
  • For example, if a gold speculator agreed to a forward contract price to buy one ounce of gold at $1,300 in one month; if at expiration, the price of one ounce of gold is $1,350 then the contract will have a value of $50 to the gold speculator.

Off Market Forward: A forward contract where the initial contract value is not set equal to zero and this value is exchanged between the buyer and seller at initiation.

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Source: financetrain.com

Category: Forex

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