Page 40 - DCOM510_FINANCIAL_DERIVATIVES

Unit 3: Introduction to Forward Contracts

3.1 Forward Contracts Notes

A forward contract is a simple customised contract between two parties to buy or sell an asset at
a certain time in the future for a certain price. Unlike future contracts, they are not traded on an
exchange, rather traded in the over-the-counter market, usually between two financial institutions
or between a financial institution and one of its clients.

Example: An Indian company buys Automobile parts from USA with payment of one
million dollar due in 90 days. The importer, thus, is short of dollar that is; it owes dollars for
future delivery. Suppose present price of dollar is ` 48. Over the next 90 days, however, dollar
might rise against ` 48. The importer can hedge this exchange risk by negotiating a 90 days
forward contract with a bank at a price ` 50. According to forward contract in 90 days the bank
will give importer one million dollar and importer will give the bank 50 million rupees hedging
a future payment with forward contract. On the due date importer will make a payment of ` 50
million to bank and the bank will pay one million dollar to importer, whatever rate of the
dollar is after 90 days. So this is a typical example of forward contract on currency.

A forward contract is an agreement between two parties to buy or sell underlying assets at a pre-
determined future date at a price agreed when the contract is entered into. Forward contracts are
not standardised products. They are over-the-counter (not traded in recognised stock exchanges)
derivatives that are tailored to meet specific user needs. The underlying assets of this contract
include:
1. Traditional agricultural or physical commodities
2. Currencies (foreign exchange forwards)
3. Interest rates (forward rate agreements or FRAs)

Example: Suppose you decide to subscribe to cable TV. As the buyer, you enter into an
agreement with the cable company to receive a specific number of cable channels at a certain
price every month for the next year. This contract made with the cable company is similar to a
futures contract, in that you have agreed to receive a product at a future date, with the price and
terms for delivery already set. You have secured your price for now and the next year-even if the
price of cable rises during that time. By entering into this agreement with the cable company,
you have reduced your risk of higher prices.
At the time the forward contract is written, a specified price is fixed at which the asset is purchased
or sold. This delivery price is referred to as the delivery price. This delivery price is set such that
the either a long (buyer) or a short (seller) position. This is done by convention so that no cash
is exchanged between the parties entering into the contracts. In this way, the delivery price
yields a ‘fair’ price for the future delivery of the underlying asset. One of the parties to a forward
contract agrees to buy the underlying asset is aid to have a ‘long’ position. On the other hand, the
party that agrees to sell the same underlying asset is said to have a ‘short’ position.

3.1.1 Definitions

A forward contract is an agreement between two parties to buyer sells, as the case may be, a
commodity (or financial instrument or currency) at a predetermined future date at a price
agreed when the contract is entered into.
The key elements are:
1. The date on which the commodity will be bought/sold is determined in advance.
2. The price to be paid/received at that future date is determined at present.

LOVELY PROFESSIONAL UNIVERSITY 35