A derivative is a product whose value is derived from the value of one or more basic variables called bases. These underlying assets or reference rates can include Equity, Forex, and Commodity.
Forward contracts represent the simplest form of financial derivatives.
Introduction and Definition A Forward contract is a bilateral contract that obliges one party to buy, and the other party to sell, a specified quantity of a nominated underlying financial instrument at a specific price, on a specified date in the future.
Nature and Features Forward contracts are bilateral contracts, which means they are agreements directly between two parties. Due to this direct relationship, they are exposed to counter-party risk. This is the risk that one of the parties may fail to perform their obligation under the contract. Each forward contract is custom designed, making each one unique. The terms that can be customized include the asset type, its quality, the contract size, and the expiration date.
Forward Terminology Several key terms are associated with forward contracts:
- Underlying Asset: This is the asset upon which the forward contract is based.
- Long Position: The party who agrees to buy the underlying asset on a future date is said to have a long position.
- Short Position: The party who agrees to sell the underlying asset on a future date holds a short position.
- Spot Position: This refers to the quoted price of the underlying asset for immediate buying and selling.
Markets and Underlying Assets There are active markets for forward contracts covering a multitude of underlying assets. Traditionally, these included agricultural or physical commodities. However, they also commonly involve currencies (Foreign Exchange Forwards) and interest rates (Forward Rate Agreements – FRAs). The sources indicate a massive volume of trade in forward contracts.
Payoff Profile The payoff profile for both the buyer (long position) and the seller (short position) of a forward contract can be illustrated. From the diagram presented in the sources, it can be seen that both the long and short forward positions break even when the spot price at expiration is equal to the forward price. For the long forward position, the maximum potential loss is limited to the forward price agreed upon in the contract. Conversely, the maximum potential gain for the long forward position is unlimited. For the short forward position, the maximum potential gain is limited to the forward price. The maximum potential loss for the short forward position, however, is unlimited. The payoff diagrams typically show the payoff of a position specifically at the expiration date.
An illustration helps clarify the payoff. If an investor sells 10 million yen forward at a forward price of $0.0090 per yen, and at expiration the spot price is $0.0083 per yen.
- The long position’s payoff at expiration is calculated as (Spot Price – Forward Price) × Quantity. In this example, it would be ($0.0083 – $0.0090) × 10,000,000 yen = -$0.0007 × 10,000,000 = -$7,000. The long position would have a loss of $0.007 million.
- The short position’s payoff is the opposite of the long position. It would be a profit of $0.007 million.
Execution of Contracts Forward contracts can be executed in several ways at or before their expiration date. The sources classify the execution methods into categories: Delivery under the Contract, Cancellation of the Contract, and Extension of the Contract.
- Delivery under the Contract: This can occur on the due date, early, or late.
- Cancellation of the Contract: A contract can be cancelled on the due date, early, or late. Cancelling a forward contract may involve specific cancellation charges. An example shows a scenario where a cancellation leads to a net amount payable, calculated after accounting for profit on cancellation. Another example mentions cancellation charges, swap loss, and interest as costs associated with handling a forward contract.
- Extension of the Contract: A contract can also be extended on the due date, early, or late. An example illustrates extending a contract at the current market forward selling rate, potentially including an exchange margin, to arrive at a new contract rate. Costs associated with extension can include cancellation charges, swap loss, and interest.
Pricing and Forward Points The difference between the spot rate and the forward rate is often referred to as forward points. These points are added to the spot rate when the foreign currency is at a premium and deducted when it is at a discount, assuming direct rate quotation. In the case of indirect rate quotations, the process is reversed. Forward points can be positive or negative. The number of forward points is influenced by the present and forward interest rates of the two currencies involved, the length of the forward period, and other market factors. A key principle is that the currency with the lower interest rate is always at a premium relative to the other currency. This reflects the interest rate differential between the two currencies.
Examples demonstrate forward rate calculations and interpretations:
- If the spot exchange rate is GBP 1 = 1.6000 – 1.6010 USD, and the outright forward points are 5-8, the outright forward exchange rate is GBP 1 = $1.6005 – 1.6018.
- A calculation example shows determining a Forward Rate (Can$/£) based on interest rates in the two currencies (7.5% and 6%) using the formula (1 + r_foreign) / (1 + r_domestic) * Spot Rate. This yielded a forward rate of Can$ 2.535/£. The same example showed a gain due to using the forward contract compared to the spot rate if the spot rate declined by 2%.
- An illustration calculates the Forward Premium or Discount by comparing the Forward Rate to the Spot Exchange Rate for different currencies (USD, F Fr, UK£, Japan Yen). For example, for USD, the Forward Rate was 48.82 [/FC] and the Spot Exchange Rate was 48.01 [/FC], resulting in a Forward Premium of 0.81. For Japan Yen, the Forward Rate was 2.40 [/FC] and the Spot Exchange Rate was 3.20 [/FC], resulting in a Forward Discount of (0.80).
Forward Rate Agreements (FRAs) A specific type of forward contract related to interest rates is the Forward Rate Agreement (FRA). An FRA is a contract, typically between a bank and a customer or another independent party, that guarantees a future interest rate for a specified sum of money over a specified future period. If the actual interest rate differs from the agreed-upon rate at the future settlement date, one party pays the other the difference between the interest cash flows based on the two rates. An example of an FRA might involve two parties agreeing that a 6 percent per annum interest rate will apply to a one-year deposit that will be made in six months’ time. The formula for determining the final settlement amount in an agreement (like an FRA) can involve the notional principal amount (N), the Reference Rate (RR) prevailing on the settlement date, the Agreed-upon Forward Rate (FR), and the maturity of the forward rate in days (dtm) divided by the days in the year (DY). The formula is shown as: Final settlement amount = (N) * (RR – FR) * (dtm/DY) / [1 + RR * (dtm/DY)].
Non-Deliverable Forward Contracts (NDFs) Another variation mentioned is the Non-deliverable Forward Contract (NDF). This is a cash-settled, short-term forward contract used for thinly traded or non-convertible foreign currencies. The profit or loss at settlement is calculated based on the difference between the agreed-upon exchange rate and the spot rate at settlement, applied to a notional amount.
Forward Contracts vs. Futures Contracts The sources briefly compare forward contracts with futures contracts. A key difference lies in the nature of the obligation. In options, the buyer has the right but not the obligation. While futures and forwards both create obligations, the source mentions that an investor with a long futures position is obligated to square off their position at or before the contract’s expiry date. (Note: While forwards also carry an obligation, the sources focus the “square off” aspect on futures in this comparison). An example calculation comparing receipts under a Forward contract versus Futures for a US$ amount shows different net receipts.
Hedging Applications Forward contracts are listed as one of the financial derivative products that can be used to hedge transaction risk. Transaction risk arises from future cash flows denominated in a foreign currency. Examples show the application of forward rates in practical scenarios:
- Calculating the obligation in local currency for a future foreign currency repayment by using a 3-months outright forward rate. This calculation can be compared to the cost of using other methods, such as an overdraft.
- Calculating net exposure in local currency (Rupee) based on the forward premium or discount of foreign currencies, suggesting that net exposure can be offset by better forward rates for currencies where the net exposure is receivable and forward rates are at a premium.
In summary, the sources provide a foundational understanding of forward contracts, covering their definition, bilateral nature, counter-party risk, customization, key terminology, application in various markets (especially foreign exchange and interest rates), the concept of payoff profiles, methods for executing or managing the contract through delivery, cancellation, or extension, and how forward points and interest rate differentials influence pricing. They also introduce specific types like FRAs and NDFs and briefly contrast forwards with futures contracts, highlighting their use in hedging transaction risk through illustrative examples and calculations.