Chapter 1: Introduction to Forward Contracts V 2.

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Chapter 1: Introduction to Forward Contracts V 2.0

Learning Objectives
After completing this chapter, you will be able to have an idea about:
Forward Markets
Profits from Forward Contracts
Characteristics of Forward Contracts
Classification of Forward Contracts
Forward Rate Agreements
Forward contracts Terminology and Mechanism
Advantages of Forward Contracts
Limitations of Forward Contracts

Certificate in Derivatives L3

Chapter 1: Introduction to Forward Contracts V 2.0

Topics Covered
Forward Contracts
Characteristics of Forward Contracts
Classification of Forward Contracts
Types of Contracts
Terminologies involved in Forward Contracts
Advantages and Disadvantages of Forward Contracts

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Chapter 1: Introduction to Forward Contracts V 2.0

Forward Contracts
Mutual agreement between two parties to deliver the underlying asset at a
certain time for certain price.
These are generally traded on OTC market.
One of the parties assumes a long position and agrees to buy the underlying
asset and the other party assumes a short position and agrees to sell the
underlying asset.
The main advantage of forward contract is that, it is used to hedge the foreign
currency risk.
Payoff for long position = Market Price at the time of maturity Strike Price
Payoff for short position= Strike Price Market Price at the time of maturity

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Chapter 1: Introduction to Forward Contracts V 2.0

Characteristics of Forward Contracts

Forward contract is an agreement between two counterparties to buy or sell an
asset at a certain time in the future for a certain price. As there is no exchange
to specify the terms of the contract, the parties entering into forward contract
should come to consensus on a mutually attractive deal.
In forward contracts, the asset size, the quantity and type of the asset has to be
clearly mentioned.
The forward contracts also specify the future date of delivery and the price that
is required to be paid at the termination of the contract.
The price that is required to be paid by the buyer to the seller should be decided
presently.
A forward contract clearly specifies that, both the buyers and sellers are
obligated when they enter into the contract.
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Chapter 1: Introduction to Forward Contracts V 2.0

There would be no transfer of money between the parties until the delivery date.
There are also other salient features that can be attributed to the forward
contracts.
The forward contracts are bilateral contracts and hence are exposed to counterparty 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 a 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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Chapter 1: Introduction to Forward Contracts V 2.0

Classification of Forward Contracts

The various classifications of forward contracts are:
Hedge Contracts
Transferable Specific Delivery (TSD) Contracts
Non-transferable Specific Delivery (NTSD) Contracts
Though these are the general classifications of the forward contracts, these are
specifically applicable in the Indian Context.

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Chapter 1: Introduction to Forward Contracts V 2.0

Hedge Contracts
The main feature of a hedge contract is that, they are easily transferable
and do not specify any particular lot, or variety of delivery for the underlying
assets.
The delivery in such contracts is necessary except in residual or optional
sense
In India, these are governed under the provisions of the Forward Contracts
Regulation Act, 1952.

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Chapter 1: Introduction to Forward Contracts V 2.0

Transferable Specific Delivery Contracts (TSD)

These forward contracts are also easily transferable from one market
participant to the other.
Unlike hedge contracts, these are concerned with specific or variety of
delivery of the underlying asset.
It is always mandatory that the delivery of the underlying asset should
take place at the expiration date itself.
In India, these are regulated by Forward Contracts Regulation Act,
1952. But the central Government has powers to exempt such forward
contracts.

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Chapter 1: Introduction to Forward Contracts V 2.0

Non-Transferable Specific Delivery Contracts

The main feature of NTSD Contracts is that, they are not at all
transferable.
It is always mandatory that the delivery of the underlying asset should
take place at the expiration date itself.
It normally happens that, these contracts are exempted from the
Forward Contracts Regulation Act, but the Central Government has
enough power to bring back them under the above mentioned regulation
act.

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Chapter 1: Introduction to Forward Contracts V 2.0

Terminologies

Long Position: The market participant which is ready to buy the underlying
asset at a certain price for a certain time in the future is said to be holding
long position.

Short Position: The market participant which is ready to sell the

underlying asset at a certain price for a certain time in the future is said to
be holding short position.

The Underlying Asset: The asset which is underlying the derivatives

contract and the value of the contract depends on the value of the
underlying asset. For example, Stock option is a derivative, where price
depends on the price of a stock.

Spot Price: It is the price of the asset for the immediate delivery. It is the
quoted price for either buying or selling of an asset at the spot.
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Chapter 1: Introduction to Forward Contracts V 2.0

Futures Spot Price: It is the market price of the underlying asset at the time
when the contract expires.
Delivery Price: It is the specified price in a forward contract. This price is
decided at the time of entering into a forward contract. The value of the contract
to both the parties is zero; therefore, the parties need not make any payment
before entering into the contract. The delivery price is dependent on the law of
supply and demand.
Forward Price: It refers to the agreed upon price at which both the
counterparties will transact when the contract expires. To state this in simpler
terms, 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

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Chapter 1: Introduction to Forward Contracts V 2.0

Advantages & Disadvantages of Forward Markets

Advantages of Forward Markets:
Since the terms of the contract are not specified by an exchange, the
parties involved in the contract are free to choose their own terms of the
contract.
The parties can enter into a mutually attractive deal.
Limitations of Forward Markets:
Forward markets world-wide are afflicted by several problems:
Lack of Centralization of Trading
Illiquidity
Counterparty Risk

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Chapter 1: Introduction to Forward Contracts V 2.0

Summary
A forward contract is a mutual agreement between two market
participants, in which the buyer and the seller agree upon the delivery of
a specified quality and quantity of asset at a specified future date at a
predetermined price
One of the parties to a forward contract assumes a Long Position and
agrees to buy an underlying asset at a specified future date at a
predetermined price
The other party assumes a Short Position and agrees to sell an
underlying asset at a specified future date at a predetermined price.
A certain price is fixed at the time the forward contract is written. This
price is termed as the delivery price.
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Chapter 1: Introduction to Forward Contracts V 2.0

Summary
The payoff/profit from a long position in a forward contract on one unit of an
asset is SM - KD. Where SM indicates the price of the asset at contract
maturity and KD indicates the delivery price.
The Payoff/Profit from a short position in a forward contract on one unit of asset
is
KD - SM.
The forward contracts are bilateral contracts and hence are exposed to counterparty 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.
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