Forwards : A Primer

1. Forwards : A Primer By A.V. Vedpuriswar

2. Introduction • In many ways, forwards are the simplest and most easy to understand derivatves. • A forward contract obligates one party to buy and the other to sell a specific quantity of an asset, at a set price, on a specific date in the future. • Typically, neither party to the contract pays anything to get into the contract.

3. A few basics • The party to the forward contract that agrees to buy the financial or physical asset is called the long. • The party to the forward contract that agrees to sell or deliver the asset is called the short. • Underlying asset can be currencies, commodities, bonds, etc. • In equity forward contracts, the underlying asset is a single stock, a portfolio of stocks, or a stock index. • On expiration date, after delivery, the contract is terminated.

4. Termination • A party to a forward contract can terminate the position prior to expiration by entering into an opposite forward contract with an expiration date equal to the time remaining on the original contract. • An alternative settlement method is cash settlement. Under this method, the party that has a position with negative value is obligated to pay that amount to the other party.

5. Players • The end user of a forward contract is typically a corporation, government unit, or non profit institution that has existing risk they wish to avoid by locking in the future price of an asset. • Dealers are often banks, but can also be nonbank financial institutions . • Ideally, dealers will balance their overall long positions with their overall short positions by entering into forward contracts with end users who have opposite risk exposures.

6. Forward Rate Agreements • A forward rate agreement (FRA) is a forward contract to borrow/lend money at a certain rate at some future date. • In practice, these contracts settle in cash, but no actual loan is made at the settlement date. • The long position in an FRA is the party that would borrow the money. • If the floating rate at contract expiration is above the rate specified in the forward agreement, the long will receive a compensation. • If the reference rate is below the contract rate, the short will receive a cash payment from the long.

7. Problem I expect to receive $1 million three months from now and enter into a cash settlement currency forward contract at Rs. 39.75/$. On the date of settlement, the actual exchange rate is Rs. 40.00/$. How will the cash settlement be done? Solution I will have to pay (40 – 39.75) (1,000,000) = Rs. 250,000 to the counterparty

8. Problem I have gone long on a currency forward contract for Euro 1 million at an exchange rate of $1.25/Euro. At settlement, the exchange rate is $1.24/Euro. What will be the cash settlement? Solution I have gone long on Euros. The Euro has depreciated. I gain. So I will pay compensation Compensation to be paid = (1.25 – 1.24) (1,000,000) = $ 10,000

9. Problem I enter into a forward contract for T bills with face value of $1 million and maturity of 90 days at a discount yield of 2.00%. What is the amount into which I have locked myself? Solution 2.00% is for 1 year For 90 days, the discount is 2 x 90/360 = 0.5% = 0.005 So settlement price = (1-.005) (1,00,000) = $995,000

10. Problem An FRA which expires in 30 days is based on a notional principal of $100,000 and 90 days LIBOR. The rate quoted is 4%. The actual rate 30 days from now is 5%. What is the cash settlement at expiration? Solution Compensation to the long = (.05 - .04) x 90/360 (100,000) = $ 250 But this compensation will apply at the end of the loan period. Discounted value = 250/[1+(.05)(90/360)] = $246.91

11. Problem Consider a $1 million FRA with a contract rate of 5% on 60 day LIBOR. If the 60 day LIBOR is 6% at settlement, how much will the long receive? Solution Compensation = (1,000,000) (0.06 -0 .05) (60/360) = 1,667 at the end of the loan period = 1667 / [1 + (0.06) (60/360)] = 1650 at the expiration of the FRA Ans: $ 1650