Page 36 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 3: Forward Contracts

Notes
Did u know? Does this mean one party has to lose?
No. Because by limiting my losses, I am in better control of my business. Let us understand this
from the perspective of both Mr X and Mr Y. Mr X will gain even if the price of sugar is ` 20 a
kg because at the time of entering the contract with Mr Y, Mr X did not know what exactly the
price of sugar would be after three months (i.e., on 1st July, 2006). So, by agreeing to sell sugar
at ` 25 a kg, Mr X is assured of a certain earning, based on which he can now plan the financial
needs of his business. Similarly, Mr Y also knows that he will have to sell out a fixed amount,
based on which he too can take care of the financial needs of his business. It will help Mr Y to
control his cost.
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. For 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. For 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.
For 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,
2006.
7. Delivery Price: The prespecified price of the underlying assets at which the forward contract
is settled on expiration is said to be delivery price. For example, in the above case, the
delivery price is ` 25 per kg. of sugar.

3.2.3 Features of Forward Contracts

The salient features of forward contracts are:

1. They are bilateral negotiated contract between two parties and hence exposed to counter
party risk.

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