Page 38 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 3: Forward Contracts

Self Assessment Notes

Fill in the blanks:
6. A …………… 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.

7. Forward contracts are not …………… products.
8. Forward contracts are bilateral negotiated contract between two parties and hence exposed
to ……………. .

9. According to ………….the value changes for the benefit of one party and at the expense of
the other.
10. Forward contracts can be worth less than ……………. .

3.3 Limitations of Forward Markets

Forward markets world-wide are afflicted by several problems:
1. Lack of centralization of trading,
2. Illiquidity, and

3. Counterparty risk
In the first of these two, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient in
that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the
possibility of default by any one party to the transaction. When one of the two sides to the
transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized
contracts, and hence avoid the problem of illiquidity, the counterparty risk still remains a very
serious issue.

Task Collect the data of forward agreements for 2010 and analyse the growth of forward
contracts in India in comparison to other developing countries.

Self Assessment

State the following are true or false:

11. Counterparty risk arises from the possibility of default by both the party to the transaction.
12. 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 short position.

13. Spot position is the quoted price of the underlying asset for buying and selling at the spot
time or immediate delivery.
14. The prespecified price of the underlying assets at which the forward contract is settled on
expiration is said to be delivery price.
15. 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.

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