Page 46 - DCOM510_FINANCIAL_DERIVATIVES

Unit 3: Introduction to Forward Contracts

3.2 Forward Terminologies Notes

The important terminologies used in forward contracts are described below:
1. Underlying Asset: This refers to the asset on which forward contract is made i.e., the long
position holder buys this asset in future and the short position holder sells this asset in
future. The various underlying assets are equity shares, stock indices, commodity, currency,
interest rate, etc. For example, in the above case, sugar (a commodity) is the underlying
asset.

2. Long Position: The party that agrees to buy an underlying asset (e.g. stock, commodity,
stock index, etc.) in a future date is said to have a long position. For example, in the above
case, Mr. Y is said to hold a long position. The long position holder on the contract agrees
to buy the underlying asset on the future date because they are betting the price will go up.
3. Short Position: The party that agrees to sell an underlying asset (e.g. stock, commodity,
indices, etc.) in future date is said to have a short position.

Example: In the above case, Mr. X is said to hold a short position. The short
position on the contract agrees to sell the security on the future date because they are
betting the price will go down.

4. Spot Position: This is the quoted price of the underlying asset for buying and selling at the
spot time or immediate delivery.

Example: In the above case, the spot price of sugar (underlying asset) is ` 23 per kg.
5. Future Spot Price: This is the spot price of the underlying asset on the date the forward
contract expires and it depends on the market condition prevailing at the expiration date.

Example: In the above case, we have considered two situations for futures spot
price i.e., ` 30 and ` 20.
6. Expiration Date: This is the date on which the forward contract expires or also referred to
as maturity date of the contract. For example, in the above case, the expiry date is 1st July,
2011.

7. Delivery Price: The pre-specified price of the underlying assets at which the forward
contract is settled on expiration is said to be delivery price.

Example: In the above case, the delivery price is ` 25 per kg. of sugar.

Self Assessment

Fill in the blanks:
4. According to ……………. ..... the value changes for the benefit of one party and at the
expense of the other.
5. Forward contracts can be worth less than ……………. .....

LOVELY PROFESSIONAL UNIVERSITY 41