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Derivative

A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. One party takes a long position by agreeing to buy the asset in the future, while the other takes a short position by agreeing to sell. This allows parties like importers to hedge against risks from currency fluctuations by locking in an exchange rate for a future transaction. Forward contracts are customized over-the-counter agreements that require full settlement at maturity and expose parties to counterparty risk.

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80 views7 pages

Derivative

A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. One party takes a long position by agreeing to buy the asset in the future, while the other takes a short position by agreeing to sell. This allows parties like importers to hedge against risks from currency fluctuations by locking in an exchange rate for a future transaction. Forward contracts are customized over-the-counter agreements that require full settlement at maturity and expose parties to counterparty risk.

Uploaded by

suhaspujari93
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Forward Contracts

A forward contract is an agreement between


two parties to buy or sell an asset at a certain
future time for a certain future price.
– Forward contracts are normally not exchange traded.
– The party that agrees to buy the asset in the future is said
to have the long position.
– The party that agrees to sell the asset in the future is said
to have the short position.
– The specified future date for the exchange is known as
the delivery (maturity) date.

1
Forward Contracts

For example, suppose that a U.S. importer


needs to buy £100,000 in six months

In order to hedge the risk that the dollar will


depreciate against the pound in six months,
which would increase the dollar price of the
pounds, the importer can enter into a
forward contract with a bank in which:
Forward Contracts

The importer agrees to buy £100,000 from


the bank at a fixed price in six months
(this is known as a long forward position)

The bank agrees to sell £100,000 to the


importer at a fixed price in six months
(this is known as a short forward position)
Forward Contracts

Suppose that the fixed price, known as the


delivery price, is $1.60/£. This means that in
six months, the importer will pay $160,000
for the £100,000 regardless of the exchange
rate that prevails at that time
Forward Contracts

In six months, if the dollar has depreciated


(i.e., the exchange rate has risen), the
importer will save by buying pounds
through the forward contract)
Forward Contracts

In six months, if the dollar has appreciated


(i.e., the exchange rate has fallen), the
importer will pay a higher price by buying
pounds through the forward contract, but
will have eliminated all uncertainty over the
cost of the pounds
Main features of forward contracts
Over the Counter (OTC) product

Customized contract terms

Less Liquid

No margin payment

Exposed to counter party risk

Settlement happens at end of contract

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