Business
Forward Contract
A forward contract is a private agreement between two parties to buy or sell an asset at a specified price on a future date. It allows businesses to hedge against price fluctuations and manage risk. Unlike futures contracts, forward contracts are customizable and traded over-the-counter, providing flexibility but also exposing parties to counterparty risk.
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eBook - PDFFundamentals of Financial Instruments
An Introduction to Stocks, Bonds, Foreign Exchange, and Derivatives
- Sunil K. Parameswaran(Author)
- 2022(Publication Date)
- Wiley(Publisher)
Such a contract is termed as a Forward Contract, for it entails the negotiation of terms and conditions in advance for a trade that is scheduled to take place on a future date. In a Forward Contract, at the time of negotiating the deal the two parties have to agree on the terms at which they will transact on the future date. The following need to be clearly spelled out: (1) the underlying asset, in this case shares of ABC; and (2) the contract size, in this case 100 shares. The delivery date and the transaction venue should also be agreed upon. In our illustration the delivery date is 15 August, and we will assume that the venue for the exchange is New York City. Finally, the price at which the deal will be consummated on 15 August should also be fixed at the time of negotiating on 15 May. Let us assume that the price that is agreed upon is $80 per share. A Forward Contract is termed as a commitment contract, for it represents an unconditional commitment to buy the underlying asset on the part of the buyer and an equivalent commitment to sell on the part of the seller. If the buyer were to renege by not paying the contractual amount on 15 August, it would be tantamount to default. Similarly, if the seller were to refuse to part with the shares on that day, it would be construed as default. 235 236 FORWARD AND FUTURES CONTRACTS In every Forward Contract there will be a party who agrees to buy the underlying asset and a party who agrees to sell the underlying asset. The first party is termed as the buyer or the long , while the counterparty is designated as the seller or the short . A Forward Contract is a customized or a private or an OTC contract. The term OTC , which stands for Over-the-Counter, connotes that such trades are not executed on an organized exchange. That is, a Forward Contract such as the one that we have described will not take place on an exchange like the NYSE.
eBook - PDF- T. V. Somanathan, V. Anantha Nageswaran, Harsh Gupta(Authors)
- 2017(Publication Date)
- Cambridge University Press(Publisher)
Part – II Forwards and Futures 37 3 Futures and Forwards As pointed out in chapter 1, futures trading, or more accurately forward trading, was the first form of derivatives trading. This chapter reviews the basic concepts of futures trading – its functions, the mechanism by which risk is transferred, the role of speculation and related issues. At the outset, it is necessary to understand clearly what futures trading means. Definitions A Forward Contract is an agreement between two parties to buy or sell, as the case may be, a commodity (or financial instrument or currency or any other underlying) on a pre-determined future date at a price agreed when the contract is entered into. The key elements are that: the date on which the underlying asset will be bought/sold is determined in advance; and the price to be paid/received at that future date is determined at present. Example 3.1 In the month of August, a rice mill agrees to buy 2.35 tonnes of rice of IR-8 variety from X, a farmer, in the following February at a price of 38,000 per tonne. This is a Forward Contract. Note that the farmer will receive (and the mill will pay) 38,000 x 2.35 = 89,300 in February irrespective of whether the market price in February is 40,000 per tonne or 36,000 per tonne. According to its terms, this contract may or may not be transferable by the mill or the farmer to any other person and accordingly may be called a ‘transferable’ or a ‘non-transferable’ Forward Contract. A futures contract is a contract to buy or sell, a standard quantity of a standardised or pre-determined grade(s) of a certain commodity at a pre- determined location(s), on a pre-determined future date at a pre-agreed price. If this definition is studied carefully, the differences between a futures contract and a Forward Contract become apparent:
eBook - ePubActuarial Finance
Derivatives, Quantitative Models and Risk Management
- Mathieu Boudreault, Jean-François Renaud(Authors)
- 2019(Publication Date)
- Wiley(Publisher)
This section lays the foundations of forwards and futures for the rest of the chapter. The content applies regardless of the underlying asset.3.1.1 Terminology
A Forward Contract or a futures contract is a contract that engages one party to buy (and the other to sell) an asset some time in the future for a price determined today at inception of the contract. That time in the future is known as the expiration, maturity or delivery date whereas the said price is known as the delivery price.The most important difference between forwards and futures is that futures are standardized and exchange-traded. Exchanges require investors to hold money aside to protect both sides of the transaction from default risk. This is usually known as the process of marking-to-market. This difference aside, forwards and futures serve the same purpose: fixing today the price at which an asset will be bought in the future.Forward Contracts and futures contracts also differ from spot contracts:- A spot contract is agreed upon today between a buyer and a seller, the asset is paid for and delivered (almost) immediately.
- A forward (futures) contract is also agreed upon today but the asset will be paid for and delivered at maturity of the forward (futures) contract.
Therefore, if you need to acquire the asset, say in 3 months, then instead of waiting 3 months and buying the asset on the spot market and paying a price viewed as random today, the Forward Contract fixes that price today.To simplify the presentation of this chapter, we will start by looking at Forward Contracts and we will come back to futures contracts in Section 3.5.3.1.2 Notation
Let us begin with the following standard notation:- K is the delivery price;
- T is the maturity date.
We say that delivery of the underlying asset will occur at time T or that the Forward Contract will mature at time T.Entering the long position of a Forward Contract, or said differently buying a Forward Contract, does not usually require an initial payment/premium. However, to avoid arbitrage opportunities, this restriction will have an impact on the right value of K. For now, we will consider that K can take any value and that entering a Forward Contract might require, or not, an upfront payment. We will come back to this issue later when we discuss the forward price
- J Robert Buchanan(Author)
- 2008(Publication Date)
- WSPC(Publisher)
Chapter 6 Forwards and Futures This chapter introduces some of the concepts and terminology associated with the buying and selling of securities such as stocks. The main issue discussed will be the pricing of Forward Contracts and futures. The present chapter will give the reader the opportunity to apply the theory of interest, the arbitrage principle, and some elementary stochastic processes to the problem of pricing two commonly traded financial derivatives. The term “derivative” is used because the values of these financial instruments is “derived” from underlying securities or commodities. The material of this chapter can also be treated as a “warm-up” exercise for the later chapters on options and the development of the Black-Scholes option pricing formula. 6.1 Definition of a Forward Contract At its essence, a forward is an agreement between two agents (which we will usually call the “party” and the “counterparty”) to buy or sell a specified quantity of a commodity at a specified price on a specified date in the future. The forward is an obligation to buy or sell at the agreed upon quantity, price, and time. If the party or counterparty breaks the agreement, they may face legal and financial consequences. Consider the situation of a manufacturer producing portable MP3 players. Their product depends upon an adequate supply of solid state memory to match the manufacturing output. If the manufacturer is concerned that the readily available supply of memory may fall short of their needs three months from now, they may enter into a Forward Contract with a memory supplier to sell them say 100, 000 units of memory for one million dollars in three months. Once the Forward Contract is established, the memory supplier must come up with the 100, 000 units of memory in three months and must sell it for one million dollars even if another buyer would be willing to pay more for it
eBook - PDFArbitrage, Hedging, and Speculation
The Foreign Exchange Market
- Ephraim Clark, Dilip K. Ghosh(Authors)
- 2004(Publication Date)
- Praeger(Publisher)
Forward Contracts are traded in the over-the-counter market and usually involve a financial institution on one side of the deal and either a client or another financial institution on the other side of the deal. One party to the deal 20 Arbitrage, Hedging, and Speculation takes a long position and agrees to purchase the asset. The other party takes the short position and agrees to sell the asset. The agreed price in the Forward Contract is called the delivery price, which is chosen so that the value of the contract to both sides is equal to zero. Consequently, it costs nothing to enter into a forward agreement. A futures contract is very similar to a Forward Contract. It is an agree- ment between two parties to buy or sell an asset at a certain time for a cer- tain price. Futures contracts are traded on organized exchanges. To facilitate trading, the exchange specifies certain standardized features of the contract, and trading takes place in such a way that the exchange is the ultimate counterparty to each transaction. Futures contracts differ from Forward Contracts in two other ways. First of all, payments are made over the life of the contract in what is called marking to market. Secondly, most futures contracts are closed out before maturity. Thus, the organized futures markets have four important features: (1) the contracts are standardized, (2) trading is organized and centralized either in one physical location such as the trading pit or in a virtual loca- tion such as a computerized order book, (3) contracts are settled through the exchange's clearinghouse, (4) contracts are marked to market each day, which means that they are revalued according to their market value. Standardized Contracts The Chicago Mercantile Exchange (CME) is one of the world's largest commercial exchanges. It began as a commodities market and for many years only commodities were traded on it.
- J Robert Buchanan(Author)
- 2012(Publication Date)
- WSPC(Publisher)
Chapter 6 Forwards and Futures This chapter introduces some of the concepts and terminology associated with the buying and selling of securities such as stocks. The main issue discussed will be the pricing of Forward Contracts and futures. The present chapter will give the reader the opportunity to apply the theory of interest, the arbitrage principle, and some elementary stochastic processes to the problem of pricing two commonly traded financial derivatives. The term “derivative” is used because the values of these financial instruments is “derived” from underlying securities or commodities. The material of this chapter can also be treated as a “warm-up” exercise for the later chapters on options and the development of the Black-Scholes option pricing formula. 6.1 Definition of a Forward Contract At its essence, a forward is an agreement between two agents (which we will usually call the “party” and the “counter-party”) to buy or sell a specified quantity of a commodity at a specified price on a specified date in the future. The forward is an obligation to buy or sell at the agreed upon quantity, price, and time. If the party or counter-party breaks the agreement, they may face legal and financial consequences. Consider the situation of a manufacturer producing portable MP3 players. Their product depends upon an adequate supply of solid state memory to match the manufacturing output. If the manufacturer is concerned that the readily available supply of memory may fall short of their needs three months from now, they may enter into a Forward Contract with a memory supplier to sell them, say, 100, 000 units of memory for one million dollars in three months. Once the Forward Contract is established, the memory supplier must come up with the 100, 000 units of memory in three months and must sell it for one million dollars even if another buyer would be willing to pay more for it
No longer available |Learn more- (Author)
- 2014(Publication Date)
- White Word Publications(Publisher)
____________________ WORLD TECHNOLOGIES ____________________ Chapter-12 Futures Contract In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a specified future date at a price agreed today (the futures price or the strike price). The contracts are traded on a futures exchange. Futures contracts are not direct securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract. In many cases, the underlying asset to a futures contract may not be traditional commodities at all – that is, for financial futures , the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The future date is called the delivery date or final settlement date . The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange. A closely related contract is a Forward Contract; they differ in certain respects. Futures contracts are very similar to Forward Contracts, except they are exchange-traded and defined on standardized assets. Unlike forwards, futures typically have interim partial settlements or true-ups in margin requirements. For typical forwards, the net gain or loss accrued over the life of the contract is realized on the delivery date.
eBook - PDF- Roy E. Bailey(Author)
- 2005(Publication Date)
- Cambridge University Press(Publisher)
This fact is neglected for simplicity. 5 See Merton (1973) for the origin of the term, albeit in a slightly different context. 340 The economics of financial markets Until the contract delivery date draws near, the open interest often exceeds the volume of the asset that could conceivably be delivered. When the prospect for delivery becomes closer, many of the contracts are offset – the parties ‘unwind their positions’ – so that, at T , the amount of the asset exchanged is quite modest. For example, in 2003 the proportion of contracts in grain futures held to maturity was about 15.4 per cent of the average open interest, and much less than 1 per cent of all the grain contracts traded during the year (Commodity Futures Trading Commission, Annual Report to Congress , 2003). 6 Indeed, many financial futures contracts are written in such a way that delivery of the asset is not permitted, even if it were physically possible; how this can be so is explained in chapter 16. 14.1.3 Distinguishing between forward and futures contracts Although forward and futures contracts share many common features, their differ-ences are crucial for understanding the operation of futures markets. 1. A Forward Contract is typically a private agreement between two identified, named parties, one of whom takes a ‘long’ position (the buyer), the other taking a ‘short’ position (the seller). With futures contracts, the identity of the party who takes the other side of the contract is irrelevant. Futures contracts are traded on formal exchanges and involve a third party, the exchange clearing house , which acts as a guarantor for the contracts. 7 Once a futures contract has been agreed, the clearing house guarantee effectively makes the contract an anonymous agreement, thus facilitating further trading in the contract prior to the stipulated delivery date.
eBook - ePub- Alastair Graham(Author)
- 2013(Publication Date)
- Routledge(Publisher)
6 Forward Exchange ContractsCurrency can be traded spot or forward. In the case of a spot transaction, the purchase or sale takes place immediately, for settlement two working days later. In the case of a forward transaction, the purchase or sale is agreed but will take place at some time in the future, thereby fixing the rate for a future exchange of currencies. Forward transactions are known as forward exchange contracts or Forward Contracts.Elements of Forward Exchange ContractsA forward exchange contract, as its name implies, is a contractually binding agreement between two parties, a bank and a non-bank customer, or two banks. Once made, a customer cannot back out of it nor alter its terms, except by arrangement with the contracting bank.Every Forward Contract has three main elements, the first two also are features of spot transactions. • It is a binding agreement to buy or sell a specific quantity of one currency in exchange for another. • The rate of exchange is fixed when the contract is made. Except in rare instances, this will not be the same as the rate for a spot transaction. • The contract is for performance, delivery of the currency, at an agreed future time, either a specific date or any time between two specific dates, depending on the contract terms. Forward Contracts: Features, Benefits and LimitationsValue DatingThe value date of an FX transaction is the date of the actual receipt and payment of the currency. • For spot transactions, the value date is two working days after the deal date. • For forward transactions, the value date is measured from the spot value date.Forward Contracts: Dealing Date and Value DateExamplesA three-month Forward Contract agreed on Tuesday May 12, will have a value date three months after the spot value date (May 14) i.e. August 14.A one-month Forward Contract agreed on Monday October 2, will have a value date one month after October 4. This will be November 4. However, November 4 will be a Saturday and not a working day, so the value date moves to Monday November 6.
eBook - PDF- Janice Loftus, Ken Leo, Sorin Daniliuc, Belinda Luke, Hong Nee Ang, Mike Bradbury, Dean Hanlon, Noel Boys, Karyn Byrnes(Authors)
- 2022(Publication Date)
- Wiley(Publisher)
LEARNING CHECK A forward exchange contract is an agreement between two parties to exchange a specifed quantity of one currency for another at a specifed exchange rate known as the forward rate. A Forward Contract has the following three characteris- tics: (1) its fair value changes with changes in exchange rates, (2) it requires no initial outlay and (3) it is settled at a future date on a net basis. A forward exchange contract to buy foreign currency involves a right to receive foreign currency and an obligation to pay A$ that is fxed at the forward rate. A forward exchange contract to sell foreign currency involves a right to receive A$ fxed at the forward rate and an obligation to provide foreign currency. The fair value of a Forward Contract at a point in time equals the present value of the gain or loss that would result if another Forward Contract with the same settle- ment date as the original contract was entered into. The fair value of a forward exchange contract to buy foreign currency at a point in time is calculated as the number of foreign currency units multiplied by the difference between the forward rate at that point in time and the forward rate of the original contract. Any increases after the contract inception in the forward rate expressed using the direct form of quotation increases the fair value of the forward exchange contract to buy foreign currency. The fair value of a forward exchange contract to sell foreign currency at a point in time is calculated as the number of foreign currency units multiplied by the difference between the forward rate of the original con- tract and the forward rate at that point in time. Any increases after the contract inception in the forward rate expressed using the direct form of quotation decreases the fair value of the forward exchange contract to sell foreign currency.
eBook - PDF- Robert Zipf(Author)
- 2003(Publication Date)
- Academic Press(Publisher)
The customers protect themselves against oil price increases and, more generally, against oil price fluctuations. They frequently pay a fee to enter the agreement. The futures contract offers the next step in trading now for future delivery. The Forward Contract was specially designed for you, and both you and the dealer expect that you will actually take delivery of the oil and pay for it. A futures contract is a standard contract that can apply to a large number of trades. The contract trades on an organized exchange, with standard contract expiration dates (called settlement or delivery dates), standard products, standard amounts of the product, quoted prices, exchange guarantees of con-tract fulfillment, margin availability and requirements, and easy and low-cost trading opportunities. You can see that the Forward Contract offers you the advantage of a contract especially designed for you and your needs. However, you cannot change it or get out of it without the agreement of the other party. The futures contract offers the advantages of uniformity, ease of trading, and guaranty of perfor-mance. However, it may not be entirely suited to your individual needs. E XAMPLE 22.1. The Chicago Board of Trade (CBOT ® or sometimes CBT), one of the major futures exchanges, has wheat contracts. The size is 5,000 bushels (minimum) and the expiration dates, in early March of 2002, were in March, July, September, and December of 2002. The CBOT also has corn con-tracts, with size of 5,000 bushels (minimum) and expiration dates, in early March of 2002, were May, July, September, and December of 2002, and March and May of 2003. E XAMPLE 22.2. In early March of 2002, the wheat contract on the Chicago Board of Trade traded at 299 cents per bushel of wheat for the future expiring in December of 2002. The contract size of 5,000 bushels meant that the value of the contract was about $15,000. You can buy a contract; this is called being “long” the contract (if you weren’t already short).
eBook - PDF- Todd Lofton(Author)
- 2006(Publication Date)
- Wiley(Publisher)
The Forward Contract may be for any amount, of any currency, for delivery at any time. There is no explicit cash mar- gin required, although banks may ask for compensating balances or other col- lateral. Futures offer other benefits. Banks generally consider $1 million as the basic unit for Forward Contracting. This may be more money than a small com- pany needs. The value of most individual foreign currency futures contracts falls in the $80,000 to $100,000 range. Another major benefit of the futures contract is its flexibility. A futures position can be reduced or abandoned altogether with- out incurring additional transaction costs. Finally, futures may offer considerably lower transaction costs, particularly if your business is not located in one of the major financial centers. Hedging Foreign currency futures are the financial futures most like the traditional futures markets. Hedging is straightforward; the holder of a foreign currency bank bal- ance would use a short futures hedge to protect against a decline in its value. An international businessman who would suffer losses if the value of a foreign cur- rency were to rise relative to his own would use a long hedge in the foreign cur- rency future. An example will make this clearer. Let’s say that Barbara Bradford, Inc., an American firm, imports designer buttons from Switzerland. The Bradford com- pany buys in large quantities and resells the buttons to U.S. manufacturers of high-fashion clothes for women. The buttons are priced in Swiss francs when 104 THE FINANCIAL FUTURES they are ordered. Because many of the buttons are specially made, there is often a considerable lapse of time between order and payment. Bradford has noticed that on some delayed orders, a large part of her expected profit has been lost to changes in the exchange rate. She has just ordered 125,000 Swiss francs worth of buttons.
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