Forwards – Chapter 2
By: Prof. N P Singh
[email protected] The Forward Contract
A forward contract is an agreement to buy or sell an
asset in the future at prices agreed upon today.
If you have ever had to order an out-of-stock textbook,
then you have entered into a forward contract.
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Features
They are bilateral contracts and hence exposed to counter-
party risk.
Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and the asset type and
quality.
The contract price is generally not available in public domain.
On the expiration date, the contract has to be settled by
delivery of the asset.
If the party wishes to reverse the contract, it has to
compulsorily go to the same counter-party, which often results
in high prices being charged.
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Forward Rate Quotations
The forward market for FOREX involves agreements
to buy and sell foreign currencies in the future at prices
agreed upon today.
Bank quotes for 1, 3, 6, 9, and 12 month maturities are
readily available for forward contracts.
Longer-term swaps are available.
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Forward Rate Quotations
Consider the example from above:
for Japanese yen, the spot rate is
¥115.75 = $1.00
While the 180-day forward rate is
£112.80 = $1.00
What’s up with that?
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Spot Rate Quotations
Currency
Wednesday, January 8, 1997 U.S. $ equiv. per U.S. $
EXCHANGE RATES Country Wed. Tues. Wed. Tues.
The New York foreign exchange selling rates below apply to
trading among banks in amounts of $1 million and more , as quoted
Japan (Yen)
30-Day Forward
90-Day Forward
.008639
.008676
.008750
.008681
.008718
.008791
115.75
115.26
114.28
115.20
114.71
113.76
Clearly the market
participants expect
at 4 p.m. Eastern time by Dow Jones Telerate Inc. and other sources. 180-Day Forward .008865 .008907 112.80 112.28
Retail transactions provide fewer units of foreign currency per Jordan (Dinar) 1.4075 1.4075 .7105 .7105
dollar. Kuwait (Dinar) 3.3367 3.3389 .2997 .2995
Lebanon (Pound) .0006445 .0006445 1551.50 1551.50
that the yen will
Currency
U.S. $ equiv. per U.S. $ Malaysia (Ringgit) .4018 .4002 2.4885 2.4990
Country Wed. Tues. Wed. Tues. Malta (Lira) 2.7624 2.7701 .3620 .3610
Argentina (Peso) 1.0012 1.0012 .9988 .9988 Mexico (Peso) .... .... .... ....
Australia (Dollar)
Austria (Schilling)
Bahrain (Dinar)
.7805
.09043
2.6525
.7902
.09101
2.6525
1.2812 1.2655
11.058 10.988
.3770 .3770
Floating rate
Netherland (Guilder)
New Zealand (Dollar)
.1278
.5655
.7072
.1277
.5699
.7106
7.8220
1.7685
1.4140
7.8330
1.7547
1.4073
be worth MORE
in dollars in six
Belgium (Franc) .03080 .03105 32.470 32.205 Norway (Krone) .1540 .1548 6.4926 6.4599
Brazil (Real) .9607 .9615 1.0409 1.0401 Pakistan (Rupee) .02529 .02529 39.540 39.540
Britain (Pound) 1.6880 1.6946 .5924 .5901 Peru (new Sol) .3814 .3840 2.6218 2.6039
30-Day Forward 1.6869 1.6935 .5928 .5905 Philippines (Peso) .03800 .03802 26.318 26.300
90-Day Forward
180-Day Forward
Canada (Dollar)
1.6843
1.6802
.7399
1.6910
1.6867
.7370
.5937
.5952
1.3516
.5914
.5929
1.3568
Poland (Zloty)
Portugal (Escudo)
Russia (Ruble) (a)
.3460
.006307
.3475
.006369
2.8900
158.55
.0001787 .0001788 5595.00 5594.00
2.8780
157.02 months.
30-Day Forward .7414 .7386 1.3488 1.3539 Saudi Arabia (Riyal) .2666 .2667 3.7503 3.7502
90-Day Forward .7442 .7413 1.3437 1.3489 Singapore (Dollar) .7116 .7124 1.4053 1.4037
180-Day Forward .7479 .7450 1.3370 1.3422 Slovak Rep. (Koruna) .03259 .03259 30.688 30.688
Chile (Peso) .002352 .002356 425.25 424.40 South Africa (Rand) .2141 .2142 4.6705 4.6690
China (Renminbi) .1201 .1201 8.3272 8.3276 South Korea (Won) .001184 .001184 844.75 844.65
Colombia (Peso) .0009985 .0009985 1001.50 1001.50 Spain (Peseta) .007546 .007603 132.52 131.53
Czech. Rep (Krouna) .... .... .... .... Sweden (Krona) .1431 .1435 6.9865 6.9697
Commercial rate .03662 .03677 27.307 27.194 Switzerland (Franc) .7334 .7387 1.3635 1.3537
Denmark (Krone) .1663 .1677 6.0118 5.9633 30-Day Forward .7357 .7411 1.3593 1.3494
Ecuador (Sucre) .... .... .... .... 90-Day Forward .7401 .7454 1.3511 1.3416
Floating rate .0002766 .0002787 3615.00 3587.50 180-Day Forward .7470 .7523 1.3386 1.3293
Finland (Markka) .2121 .2135 4.7150 4.6841 Taiwan (Dollar) .03638 .03637 27.489 27.493
France (Franc) .1879 .1893 5.3220 5.2838 Thailand (Baht) .03902 .03906 25.625 25.605
30-Day Forward .1882 .1896 5.3126 5.2741 Turkey (Lira) .00000911 .00000915 109755.00 109235.00
90-Day Forward .1889 .1903 5.2935 5.2558 United Arab (Dirham) .2723 .2723 3.6720 3.6720
180-Day Forward .1901 .1914 5.2617 5.2243 Uruguay (New Peso) .... .... .... ....
Germany (Mark) .6352 .6394 1.5744 1.5639 Financial .1145 .1145 8.7300 8.7300
30-Day Forward .6364 .6407 1.5714 1.5607 Venezuela (Bolivar) .002098 .002096 476.70 477.12
90-Day Forward .6389 .6432 1.5652 1.5547 ---
180-Day Forward .6430 .6472 1.5552 1.5450 SDR 1.4315 1.4326 .6986 .6980
Greece (Drachma) .004049 .004068 246.98 245.80 ECU 1.2308 1.2404 .......... ...........
Hong Kong (Dollar) .1292 .1292 7.7390 7.7390
Hungary (Forint) .006139 .006164 162.89 162.23 Special Drawing Rights (SDR) are based on exchange rates for
India (Rupee) .02787 .02786 35.875 35.890 the U.S., German, British, French, and Japanese currencies. Source:
Indonesia (Rupiah) .0004233 .0004233 2362.15 2362.63 International Monetary Fund.
Ireland (Punt) 1.6664 1.6714 .6001 .5983 European Currency Unit (ECU) is based on a basket of community
Israel (Shekel) .3079 .3085 3.2474 3.2412 currencies.
Italy (Lira) .0006483 .0006510 1542.50 1536.00 a-fixing, Moscow Interbank Currency Exchange.
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Long and Short Forward Positions
If you have agreed to sell anything (spot or forward),
you are “short”.
If you have agreed to buy anything (forward or spot),
you are “long”.
If you have agreed to sell forex forward, you are short.
If you have agreed to buy forex forward, you are long.
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Payoff Profiles
profit If you agree to sell anything in the future at a set
price and the spot price later falls then you gain.
S180($/¥)
0
F180($/¥) = .009524
If you agree to sell anything in the future at a set
price and the spot price later rises then you lose.
loss Short position
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Payoff Profiles
profit
short position
Whether the payoff
profile slopes up or down
depends upon whether
you use the direct or
indirect quote:
0 F180(¥/$) = 105 or
S180(¥/$)
F180($/¥) = .
F180(¥/$) = 105 009524.
-F180(¥/$)
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loss
Payoff Profiles
profit
short position
S180(¥/$)
0
F180(¥/$) = 105
When the short entered into this forward contract,
he agreed to sell ¥ in 180 days at F180(¥/$) = 105
-F180(¥/$)
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loss
Payoff Profiles
profit
short position
15¥
S180(¥/$)
0
120
F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the short will
-F180(¥/$) make a profit by buying ¥ at S180(¥/$) = 120 and
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loss delivering ¥ at F180(¥/$) = 105.
Payoff Profiles
profit Since this is a zero-sum game, the long position
F180(¥/$) payoff is the opposite of the short. short position
S180(¥/$)
0
F180(¥/$) = 105
-F180(¥/$) Long position
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loss
Payoff Profiles
profit
The long in this forward contract agreed to BUY
-F180(¥/$)
¥ in 180 days at F180(¥/$) = 105
If, in 180 days, S180(¥/$) = 120, the long will
lose by having to buy ¥ at S180(¥/$) = 120
and delivering ¥ at F180(¥/$) = 105.
S180(¥/$)
0
120
F180(¥/$) = 105
–15¥
Long position
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loss
Limitations
Forward markets world-wide are afflicted by several
problems:
Lack of centralization of trading,
Illiquidity, and
Counterparty risk
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