What are forward contracts?
A forward contract is a customised contract between two parties to buy or sell an asset at a specified price on a future date. Or we can say, Forward contract is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. Forwards are widely used in commodities, foreign exchange, equity and interest rate markets.
The key characteristics of a forward are as follows:
One of the counterparties is referred to as the “long position” or “long forward,” and the other counterparty is referred to as the “short position” or “short forward.”
The long forward is obligated to purchase an asset from the short forward at a future point in time. The short forward is obligated to sell the asset.
The asset is known as the “underlying asset.” The underlying asset can be any asset. Common examples include stocks, bonds, currencies, and commodities.
The future point in time when the transaction occurs is known as the “expiration date.” For example, a forward may have an expiration date that is three months after initiation
The price at which the underlying asset is purchased is called the “forward price.” The forward price is set at initiation though the transaction only takes place in the future
The long forward is obligated to purchase an asset from the short forward at a future point in time. The short forward is obligated to sell the asset.
The asset is known as the “underlying asset.” The underlying asset can be any asset. Common examples include stocks, bonds, currencies, and commodities.
The future point in time when the transaction occurs is known as the “expiration date.” For example, a forward may have an expiration date that is three months after initiation
The price at which the underlying asset is purchased is called the “forward price.” The forward price is set at initiation though the transaction only takes place in the future
Now, let us take an example:
Now suppose you do not want to buy gold on March 9, 2015, but only after 1 month. Goldsmith quotes you Rs.15,450 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have bought forward or you are long forward, whereas the goldsmith has sold forwards or short forwards. There is no exchange of money or gold at this point of time. After 1 month, you come back to the goldsmith pay him Rs. 15,450 and collect your gold. This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the point of delivery.
Numerical Example
For example, consider the following scenario:
■ Initiation = June 15
■ Expiration = August 15
■ Underlying asset = one share
■ Forward price = $100
Obligates the long forward to purchase a single share from the short forward on August 15 for the forward price of $100. Hence, at expiration the long position pays $100 and receives one share in return.
Obligates the short forward to sell a single share to the long forward on August 15 for the forward price of $100. Hence at expiration the short forward receives $100 and delivers one share in return.
LONG FORWARD PAYOFF
Payoff is the cash flow that occurs at expiration. A long forward is obligated to purchase the asset through paying the forward price at expiration. Hence, the long forward’s payoff is the value of the underlying asset that it receives at expiration minus the forward price it pays. The value of the underlying asset at expiration is its market price at that time.
The long forward’s payoff can be positive, negative, or zero:
- Positive payoff occurs when the price of the asset received is greater than the forward price paid.
- Negative payoff occurs when the price of the asset received is less than the forward price paid.
- Zero payoff occurs when the price of the asset received is equal to the forward price paid.
We can describe the long forward’s payoff using an equation:
Long forward payoff = underlying asset price on the expiration date − forward price
Let’s define the following notation:
T = Expiration date
ST = Underlying asset price at time T
F = Forward price
With this notation, we can rewrite the equation for the long forward’s
payoff:
Long forward payoff = ST – F
For example, consider the following scenario:
- Initiation = June 1
- Expiration = July 1
- Forward price = $150
- Underlying asset price on July 1 = $200
In this example, the long forward’s payoff is:
Long forward payoff = ST − F
= $200 − $150
= $50
LONG FORWARD P&L
A long forward’s payoff and P&L are identical. After all, the long forward does not pay nor receive a cash flow at initiation. The equation for a long forward’s P&L is therefore identical to the equation for the long forward’s payoff:
Long forward P&L = Long forward payoff = ST – F
The long forward may experience a profit, suffer a loss, or break even:
- Profit occurs when the price of the asset received is greater than the forward price paid.
- Loss occurs when the price of the asset received is less than the forward price paid.
- Breakeven occurs when the price of the asset received is equal to the forward price paid.
We can describe the long forward’s breakeven point using an equation:
Long forward breakeven point ∶ ST = F
For example, consider the following scenario:
- Initiation = May 10
- Expiration = July 15
- Forward price = $1,500
- Underlying asset price on July 15 = $1,250
In this example, the long forward’s P&L is:
Long forward P&L = ST − F
= $1, 250 − $1, 500
=−$250
SHORT FORWARD PAYOFF
A short forward is obligated to sell an asset at expiration in return for which it receives the forward price. Hence, the short forward’s payoff at expiration is the forward price received minus the price of the asset it delivers.
The short forward’s payoff can be positive, negative, or zero:
- Positive payoff occurs when the forward price received is greater than the price of the asset delivered.
- Negative payoff occurs when the forward price received is less than the price of the asset delivered.
- Zero payoff occurs when the forward price received is equal to the price of the asset delivered.
The short forward’s payoff can be expressed as:
Short forward payoff = F – ST
For example, consider the following scenario:
- Initiation = October 3
- Expiration = February 1
- Forward price = $65
- Underlying asset price on February 1 = $82
In this example, the short forward’s payoff is:
Short forward payoff = F − ST
= $65 − $82
=−$17
SHORT FORWARD P&L
A short forward’s P&L is equal to its payoff as the only cash flow associated with a short forward is the payoff that takes place at expiration. Therefore, the equation for the short forward’s P&L is identical to the equation for the short forward’s payoff:
Short forward P&L = Short forward payoff = F – ST
The short forward may experience a profit, suffer a loss, or break even:
- Profit occurs when the forward price received is greater than the price of the asset delivered.
- Loss occurs when the forward price received is less than the price of the asset delivered.
- Breakeven occurs when the forward price received is equal to the price of the asset delivered.
We can describe the short forward’s breakeven point using an equation:
Short forward breakeven point ∶ ST = F
For example, consider the following scenario:
- Initiation = May 21
- Expiration = June 3
- Forward price = $140,000
- Underlying asset price on June 3 = $130,000
In this example, the short forward’s P&L is:
Short Forward P&L = F − ST
= $140, 000 − $130, 000
= $10, 000
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