Chapter 2
Forward Contract
2.1 Concept & Meaning of Forward Contracts
2.2 Mechanics of Forward Contracts
2.3 Pricing of the Forwards
2.4 Hedging in Forward Contracts
2.1 CONCEPT & MEANING OF FORWARD CONTRACTS
A forward contract is a simple customized contract between two parties to buy or sell an
asset at a certain time in the future for a certain price. Unlike future contracts, they are not
traded on an exchange, rather traded in the over-the-counter market, usually between two
financial institutions or between a financial institution and one of its clients.
In brief, a forward contract is an agreement between the counter parties to buy or sell a
specified quantity of an asset at a specified price, with delivery at a specified time (future)
and place. These contracts are not standardized; each one is usually customized to its
owner’s specifications.
Features of forward contract
The basic features of a forward contract are given in brief here as under:
1. Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to
counter - party risk.
2. More risky than futures: There is risk of non-performance of obligation by either of the
parties, so these are riskier than futures contracts.
3. Customised contracts: Each contract is custom designed, and hence, is unique in terms
of contract size, expiration date, the asset type, quality, etc.
4. Long and short positions: In forward contract, one of the parties takes a long position by
agreeing to buy the asset at a certain specified future date. The other party assumes a
short position by agreeing to sell the same asset at the same date for the same specified
price. A party with no obligation offsetting the forward contract is said to have an open
position. A party with a closed position is, sometimes, called a hedger.
5. Delivery price: The specified price in a forward contract is referred to as the delivery
price. The forward price for a particular forward contract at a particular time is the
delivery price that would apply if the contract were entered into at that time. It is important
to differentiate between the forward price and the delivery price. Both are equal at the
time the contract is entered into. However, as time passes, the forward price is likely to
change whereas the delivery price remains the same.
6. Synthetic assets: In the forward contract, derivative assets can often be contracted from
the combination of underlying assets, such assets are often known as synthetic assets in
the forward market. The forward contract has to be settled by delivery of the asset on
expiration date. In case the party wishes to reverse the contract, it has to compulsorily
go to the same counter party, which may dominate and command the price it wants as
being in a monopoly situation.
7. Pricing of arbitrage based forward prices: In the forward contract, covered parity or
cost-of-carry relations are relation between the prices of forward and underlying assets.
Such relations further assist in determining the arbitrage-based forward asset prices.
8. Popular in forex market: Forward contracts are very popular in foreign exchange market
as well as interest rate bearing instruments. Most of the large and international banks
quoted the forward rate through their ‘forward desk’ lying within their foreign exchange
trading room. Forward foreign exchange quotes by these banks are displayed with the
spot rates.
9. Different types of forward: As per the Indian Forward Contract Act- 1952, different
kinds of forward contracts can be done like hedge contracts, transferable specific
delivery (TSD) contracts and non-transferable specific delivery (NTSD) contracts. Hedge
contracts are freely transferable and do not specify, any particular lot, consignment or
variety for delivery. Transferable specific delivery contracts are though freely
transferable from one party to another, but are concerned with a specific and
predetermined consignment. Delivery is mandatory. Non-transferable specific delivery
contracts, as the name indicates, are not transferable at all, and as such, they are highly
specific.
Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The confusion is primarily because
both serve essentially the same economic functions of allocating risk in the presence of
future price uncertainty. However futures are a significant improvement over the forward
contracts as they eliminate counterparty risk and offer more liquidity. Table below shows
the difference between the two –
Futures Forwards
1. Trade on an organised exchange OTC in nature
2. Standardised contract terms Customised contract terms
3. Hence more liquid Hence less liquid
4. Requires margin payments No margin payment
5. Follows daily settlement Settlement happens at end of period
2.2 MECHANICS OF FORWARD CONTRACTS
The growth of futures markets followed the growth of forward market. In early years, there
were no so much transporting facilities available, and hence, a lot of time was consumed to
reach at their destination. Sometimes, it took so much time that the prices drastically
changed, and even the producers of the goods had to sell at loss. Producers, therefore,
thought to avoid this price risk and they started selling their goods forward even at the
prices lower than their expectations. For example, a farmer could sell the produce forward
to another party. And by the time the actual goods reached the market, he could have
protected himself against the future unfavourable price movements. This is known as short
selling. On the other hand, the long position holder agrees to buy the grain at a pre-
specified price and at a particular date. For this trading, a middleman is needed who knows
the expectations of buyers and sellers and he charges fees for this purpose known as
commission.
Another important point arises, in above said forward arrangements, who would be willing
to take the other side of the contract. Who would be the purchaser (or long) be? One such
possibility is that the speculator or arbitrageur may come forward and take the short
position. Second, a miller, for example, might need to purchase grain in six months to fulfil a
future commitment of delivering flour at an already agreed upon price. So to protect his
profit margin, the miller could purchase grain forward, booking both the fixed price at some
price per quintal, as well as a source of supply. In this way, he could achieve by taking the
long side of the producer’s forward contract.
2.3 PRICING OF THE FORWARDS
Forward contracts are very much popular in foreign exchange markets to hedge the foreign
currency risks. Most of the large and international banks have a separate ‘Forward Desk’
within their foreign exchange trading room which are devoted to the trading of forward
contracts. Let us take an illustration to explain the forward contract.
As discussed earlier, forward contracts are generally easier to analyze than futures contracts
because in forward contracts there are no daily settlement and only a single payment is
made at maturity. Both futures prices and forward prices are closely related. It is important
to know about certain terms before going to determine the forward prices such as
distinction between investment assets and consumption assets, compounding, short selling,
repo rate and so on because these will be frequently used in such computation. We are not
discussing these here as under:
An investment asset is an asset that is held for investment purposes, such as stocks, shares,
bonds, treasury, securities, etc. Consumption assets are those assets which are held
primarily for consumption, and not usually for investment purposes. There are commodities
like copper, oil, food grains etc.
THEORY QUESTIONS
Question 1: Define forward contracts. Discuss the various merits and demerits of forward
contract.
(AM-7 Marks Summer-15)
Question 2: A company knows that it is due to receive a certain amount of a foreign
currency in 4 months. What type of derivative contract is appropriate for hedging? (Explain
with the help of an example)
(AM-7 Marks Summer-15)
Question 3: Explain the difference between marking-to market margin and initial margin.
(AM-7 Marks Summer-15)
Question 4: Explain the characteristics of a forward contract.
(AK-7 Marks Summer-14)
Question 5: Explain carefully the difference between hedging, speculation and arbitrage.
(AK-7 Marks Summer-14)
Question 6: What is forward contract? State the advantages and disadvantages of forward
contracts.
(AH-7 Marks Winter-12)
Question 7: How are swaps related to forward contracts? What is coupon swap and
currency coupon swap?
(AH-7 Marks Winter-12)
Question 8: Define forward contract and discuss the trading mechanism of forward market.
(AD-7 Marks Winter-10)
PRACTICAL QUESTIONS
Question 1: A stock index currently stands at 4260. The risk-free rate is 6% per annum (with
continuous compounding) and dividend yield on the index is 4% per annum. What should be
the forward price for 3 months contract?
(AM-7 Marks Summer-15)
Question 2: Silver is currently trading in the bullion market at a price of Rs. 14750/- kg. A
one year forward price is Rs. 15700/- kg. The appropriate carrying cost is 7.5%, is there an
arbitrate opportunity? If so, how can this are exploited?
(AM-7 Marks Summer-15)
Question 3: What is the difference between entering into a long forward contract when the
forward price is Rs. 50 and taking a long position in a call option with a strike price of Rs. 50?
Explain with the help of pay off.
(AK-7 Marks Summer-14)
Question 4: An investor enters into a short forward contract to sell Indian Rs. 1,00,000 for
US dollars at an exchange rate of Rs. 40.25 per dollar. How much does the investor gain or
lose if the exchange rate at the end of the contract is
(i) Rs. 40.12 per dollar.
(ii) Rs. 40.35 per dollar.
(AK-7 Marks Summer-14)
Question 5: Suppose that on January 1, price of Reliance share is RS. 450 and two parties
enter into a forward contract for delivery of 1000 shares of Reliance on April 15, of a price of
RS. 460. Find out the profit/loss of seller (short position) if the price of Reliance share turns
out to be
(i) RS. 470
(ii) Rs. 400 on April 15.
(AD-7 Marks Winter-10)