Page 44 - DCOM510_FINANCIAL_DERIVATIVES

Unit 3: Introduction to Forward Contracts

Notes

Caselet Mr. X (Short Position) Wishes to Offset his Position

uppose Mr. X, the wholesale dealer of sugar wishes to get out of his initial short
forward position (of delivering 50 kgs. sugar to Mr. Y at ` 25 per kg on 1st July, 2011)
Sbefore the maturity. Let us say, on 1st May, 2011, Mr. X decided to get out of his
position and hence enters into forward another contract with Mr. W in which he agrees to
buy (offsetting position, since Mr. X initial position was to sell) from Mr. W 50 kgs. of
sugar at ` 24 and this contract expires on 1st July, 2011.
Let us consider the Time Line of Mr. X

Procter & Gamble Co.
st
st
1 April, 2011
st
st
1 April, 2011 1 May,2011 1 July,2011
st
1 May, 2011
st
1 July, 2011

Enters into Short Enters another Long Long Forward and
Enters another Long
Enters into Short Long Forward and
Forward with Mr.Y
Forward with Mr.W
Short Forward
Forward with Mr.Y Forward with Mr.W Short Forward
st
st
st
(expiry on 1 July, 2011)
(expiry on 1 July, 2011)
st
Expires
(expiry on 1 July, 2011 (expiry on 1 July, 2011 Expires
Profit/Loss position of Mr. X (on 1st July, 2011) after offsetting his initial forward position
is as follows:
Buying 50 kgs. at ` 24 to Mr. W, and cash outflow (payment) - ` 1,200
Selling 50 kgs. at ` 25 to Mr. Y, and cash inflow (receive) + ` 1,250
Total Gain + ` 50
A strong reason for Mr. X to offset his position could be that he is in short supply of sugar
and in order to fulfil his short position of delivering 50 kgs. to Mr. Y, he enters into a long
forward (promise to buy) with Mr. W.
Source: Bishnupriya M., Sathya S. D. “Financial Derivatives”. Excel Books (2007).
3.1.4 Forward Contract Mechanism
A forward contract is an effective hedging mechanism similar to an insurance policy, as it
protects a trader from unfavourable exchange rate movements. The trading mechanism of forward
contracts can be better understood through the following example.
Example: Suppose Mr. X is a wholesale sugar dealer and Mr. Y is the prospective buyer.
The current price (on 1st April, 2011) of sugar per kg. is ` 23. Mr. Y agrees to buy 50 kgs. of sugar
at ` 25 per kg after three months (1st July, 2011).
The price is arrived at on the basis of prevailing market conditions and future perceptions about
the price of sugar. If on 1st July, 2011). The market price of sugar is ` 30 per kg, then Mr. Y is a
gainer by ` 5 per kg and if the price of sugar is ` 20 per kg, then Mr. X is a gainer by ` 5 per kg.
One party’s gain is another part’s loss by the same amount.

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