A forward contract is a commitment between two parties to do a transaction at a later date with the price and terms set in advance. It is assumed that no money changes hands at the beginning of the contract.
Long and short parties
A forward agreement is between two parties, one is the buyer (called the long) and the other the seller (the short), who agree to do a transaction at a future date at a specified price. No money changes hands when the agreement is made. A forward transaction locks in the price, so the parties are unaffected by price changes between the date when the contract is agreed and the expiry of the contract. An example of an investment manager using forwards would be if a manager has to meet redemptions from a fund and will need to sell U.S. securities in two months’ time. He could enter into a forward transaction today where he takes a short position thereby locking in the sale price of the securities.
On expiry of the contract there are two ways that the parties can settle.
In either case both parties are subject to default risk, the party who has made a profit bears the risk that the other party does not settle.
Termination of a contract
Usually both parties enter into a forward contract on the basis that they will hold it through to expiry. However, there are situations where one party will wish to terminate the contract prior to expiry. The party can go into the market and enter into an offsetting contract. For example, if the party who wishes to terminate the contract had a long position, they could enter into a new contract with the same underlying asset and expiry date, this time taking the short position. This will remove the net exposure to the asset.
Alternatively the party could look at entering into a second contract with the same party to avoid having two sets of counterparty risk outstanding. In this case, the contracts will be cancelled and the parties will exchange the present value of the value of the contract at expiry.
We now look at the different types of forward contracts. They are categorized on the basis of the underlying asset to the contract.
These are contracts for the purchase of individual stocks, a portfolio of stocks or a stock index.
Equity forwards make payments based on the return of the index or price movement of the stock, which does not include dividends, unless a total return index is specifically referred to.
A forward contract on a bond or bond index is similar to an equity forward. However there are some differences; a forward contract on a bond must expire before the bond matures and a forward contract must specify what happens if a bond defaults (and how a default is defined). Also, if a bond has an embedded option or convertibility, this must be considered in the terms of the contract.
If we look at the forward contract for a risk-free zero-coupon bond, in this case a Treasury bill, the prices are quoted in terms of the discount rate. The interest is deducted from the face value of the bill and is calculated based on a 360-day year (e.g. if a 180-day T-bill is selling at a discount of 3%, its price will be $1.00 – 0.03(180/360) = $0.985.
Forward contracts on coupon bond prices are usually quoted with accrued interest, and prices are often quoted by stating the yield.
Currency forwards are widely used in the investment business and also by banks and corporations to manage currency risk.
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