Forward Markets and Contracts

A forward contract is an agreement between two parties to buy or sell an underlying asset at a pre-specified price on a pre-specified date in the future. The assets underlying a forward contract could be anything, such as a commodity (gold, oil, cotton, etc.), or financial instruments (equity, T-bills, currencies, etc.).  

Forward contracts are private contracts and are traded over-the-counter between two parties. As opposed to a <a href="https://financetrain.com/introduction-to-futures-contracts/" title="Introduction to Futures Contracts">futures contract</a>, they are not <a href="https://financetrain.com/exchange-traded-versus-over-the-counter-otc-derivatives/" title="Exchange-traded versus Over-the-counter (OTC) Derivatives">exchange traded</a>, and do not have standardized features. Instead they are customized to meet the specific needs of the two parties.

The forward contracts are primarily used as a way of hedging a preexisting risk. The following video from Khan Academy provides a wonderful introduction about how forward contracts work and how they help the different parties in the contract.

<iframe width="600" height="338" src="http://www.youtube.com/embed/H9UEZdAnnt8?rel=0" frameborder="0" allowfullscreen></iframe>

The above video takes the example of agriculture products to illustrate how a forward contract works. In the next articles, we will take the example of a financial instrument (T-bill) to illustrate the working of a forward contract and the risks involved.


Introduction to Forward Contracts

We learned that a <a href="https://financetrain.com/introduction-to-forward-contracts/" title="Introduction to Forward Contracts">forward contract</a> is a contract between two parties to buy/sell an underlying asset at a specified price on a specified date. 

In this contract, the party that agrees to buy the underlying asset has a long forward position and the party that agrees to sell the underlying asset has a short forward position. 

Since these are non-standardized contracts traded over-the-counter, there is also settlement/delivery risk and default risk.

Let's take the example of a forward contract with a T-bill as the underlying asset to illustrate how a forward contract works.

Assume a 180-day T-bill selling at 4%. This means that a $1,000 par T-bill is selling at $1,000 -  $1000*0.04*(180/360) = $980. If this T-bill is held till maturity, it will fetch $1,000 to the investor.

Two parties can enter into a forward agreement such that Party A will buy this T-bill from Party B at a price of $985 30 days from now. This will be a forward contract.

Note that Party A is long the forward contract and Party B is short the forward contract. Both parties have fixed the price and time at which the T-bill will be delivered by Part B to Party A.

Irrespective of how the price moves after 30 days, the contract needs to be fulfilled by both parties, i.e., Party A will buy the T-bill from Party B at $985.

At the time of contract initiation, the contract has zero value, however, after the beginning of the contract, as the T-bill price changes, the contract will have some value, i.e., only one party will owe some money to the other. The contract will have negative value for the person who owes money, and it will have positive value for the person who is expected to receive money. Assume that the T-bill has a price of $990 on settlement date. The contract has a positive value of Part A and negative value for Party B.

Unlike a futures contract, a forward contract also doesn’t involve any cash flow (such as margin) at the initiation of the contract.

Due to this, there is a risk of default for both counterparties because there is a possibility that one of the parties will not fulfill its obligation. In the above case, where the T-bill price is $990 on settlement date, compared to the forward price of $985, there is a possibility of Party B defaulting on its obligation.


Forward Contracts – Settlement/Default Risk (T-bill Example)

A <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contract</a> can be settled in two ways: Delivery or Cash Settlement.

In case of a deliverable forward contract, the party that is short the forward contract will actually deliver the underlying asset to the party that is long the forward contract. The underlying will be delivered on the settlement date or the expiration date as specified in the contract. The underlying will be delivered and the forward price will be received.

In case of a cash settled forward contract, the party for whom the contract has a negative value will pay the amount of negative value to the party with the positive value.

Consider our previous example where Party A will buy the T-bill from Party B at a price of $985 30 days from now. If the T-bill has a price of $990 on settlement date, then the contract has a positive value of $5 for Part A and an equivalent negative value for Party B. In this case, Party B will complete the contract by paying $5 to Party A. If, on the other hand, the T-bill price was $980 on settlement date, then Party A would have to pay $5 to Party B to fulfill the contract. In both cases, the cost of the T-bill has been fixed at $985. If Party A purchased the T-bill from the market, it will pay $980 for it but will also paid $5 to Party B under the forward contract making the total cost equal to $985.

We can generalize the payment behavior by saying that:
<ul>
	<li>If the price of the asset is above the forward price, then long receives the payment.</li>
	<li>If the price of the asset is below the forward price, then the short will receive the payment.</li>
</ul>
In this article we saw how a contract is settled on expiry. In the next article we will look at the scenario where one of the parties wants to terminate the contract prior to the expiration.

&nbsp;

How is a Forward Contract Settled?

In a <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contract</a>, both parties are required to fulfill their obligation on the expiration date. Then what would happen if a counterparty wants to exit its position prior to expiration? The forward market does not have a provision of cancelling the contract.

Instead, a party can terminate its position by entering into an opposite forward contract that has the same expiration date as the original contract.

Let’s take our previous example where Party A will buy the T-bill from Party B at a price of $985 30 days from now.

Assume that 10 days have passed, and after 10 days a 20-day forward price of a 90-day T-bill is $988. At this time, the original contract effectively has a negative value of $3 for the short (Party B). Party B expects price to rise even more and wants to control its losses. He can terminate/exit this contract by entering into an opposite forward contract to buy the T-bill at a price of $988 with an expiry 20 days from now (same day as the original contract).

The short (Party B) now has two opposite obligations:
<ol>
	<li>To sell a T-bill for $985 after 20 days</li>
	<li>To buy a T-bill (identical) for $988 after 20 days</li>
</ol>
This way Part B has locked in its loss at $3 irrespective of how the market price moves.

Note that the new opposite contract can be with the same counterparty (Party A) or with another party altogether. If the second contract is with the same counterparty, there is no credit risk. Party B can make the net payment of $3 to Party A at the time of contract expiry. In such a case, the counterparty (Party A) may even allow for an early termination of the original contract, if Party B agrees to make an immediate payment.

However, if the new contract is with another counterparty, the credit risk still exists, because the counterparty in the second transaction may not fulfill its obligation.

Forward Contract Termination Prior to Expiry

People may use a <a href="https://financetrain.com/introduction-to-forward-contracts/" title="Introduction to Forward Contracts">forward contract</a> for a variety of reasons, for example, a farmer may want to lock-in the price of its crop that will be available for sale after three months, or an importer may want to lock-in the exchange rate at which it will make the future payment for imports. These people are the hedgers who have a risk that they want to mitigate. These end users will usually be corporations, non-profit organizations, and government entities. The typical users are farmers, manufacturers, importers and exporters.

Assume that a US importer has imported some goods from India and is expected to make the payment in Indian Rupees (INR) after 90 days. Since the US importer doesn’t have control over the exchange rate after 90 days, there is foreign exchange risk in this transaction. The importer can enter into a forward contract to purchase the required amount of Indian Rupees for a fixed amount of US dollars after 90 days. This way the US importer knows exactly how much it will pay in terms of US dollars after 90 days.

Apart from hedging purpose, there are also market participants who want to benefit by taking risk in futures and forwards market. These are the speculators who want to benefit from fluctuations in prices. So, while hedgers want to reduce their risk, speculators want to take risk.

Since the forward contracts are not traded on any exchange, the end users need to find a counterparty for the contract. The end-users will use a dealer to find the counterparty that will be willing to take the opposite position. The dealer may itself take the opposite position or will find a counterparty. It is important to note that, unlike an agent, a dealer will actually take the position and will have a long or short position in the contracts. Dealers will usually balance their long and short positions by entering into long and short positions in different forward contracts. They will earn a spread on the price difference between the long and short position.  The dealer’s desk will quote a buying price to take a long position, and a selling price to take a short position. The selling price will be a bit higher than the buying price, and the dealer will earn the bid/ask spread.

Apart from the end users, the dealers will also enter into forward contracts with other dealers in order to hedge their own long/short positions.

The dealers are usually the banks and other security dealers.


End-user Vs. Dealers in a Forward Contract

An equity <a href="https://financetrain.com/introduction-to-forward-contracts/" title="Introduction to Forward Contracts">forward contract</a> works in the same way as any other forward contract except that it has a stock, a portfolio of stocks or an equity index as the underling asset. It is an agreement between two parties to buy a pre-specified number of an equity stock (or a portfolio or stock index) at a given price on a given date.

Think of an investor who holds 1,000 shares of Google and wants to sell them after 60 days. Since there is uncertainty about the price of the stock after 60 days, the investor can enter into a forward contract to sell these stocks after 60 days at a price determined today. After 60 days, irrespective of what the market price of the stock is, the investor will have to deliver the stock to the counterparty at the prefixed price.

The equity forwards can be deliverable or cash settled, except when the underlying is an equity index. The forward contract on an equity index will be cash-settled.

To enter into an equity forward contract, the seller or the buyer will have to request a quote from the dealer by providing the stock specifications. 

<strong>Example – Equity Index Forward Contract</strong>

Let’s take an example of an equity index forward contract. Assume that a portfolio manager maintains a portfolio of stocks that closely follows the S&P 500 index. He is expecting to generate $1 million from the portfolio 90 days from now. In order to guarantee a return of $1 million from the portfolio, the portfolio manager can sell (take a short position) in an equity index forward contract. He approaches a dealer and receives a quote of 500 for a notional amount of $1million.

On the settlement date, the index has moved to 480. 

Since the portfolio manager has a short position in the forward contract, and the index is below the quoted value of 500, the long will pay the difference to the short. 

The index has moved down by (500-480)/500 = 4%.

So, the long will pay 4% of $1million = $40,000 to the short (portfolio manager).

Since the index has moved down, the portfolio manager’s returns from the portfolio will reduce. However, he will gain the equivalent amount from his short position in the forward contract. This way the portfolio manager has achieved his target return of $1million from his portfolio. 


How Equity Forward Contracts Work?

The <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contracts</a> on bonds are similar to <a title="How Equity Forward Contracts Work?" href="https://financetrain.com/how-equity-forward-contracts-work/">equity forward contracts</a> except that they have bonds as the underlying asset. The forward contracts can be written on both zero-coupon bonds (such as T-bills in the US) and coupon paying bonds.

Since bonds have a maturity date, the forward contracts on these bonds must also settle before the maturity date of the bond.

We had earlier taken an example of a 180-day T-bill selling at 4%. This 4% is the annualized discount rate at which the T-bill is selling. This means that a $1,000 par T-bill is selling at $1000*0.04*(180/360) = $980. If this T-bill is held till maturity, it will fetch $1,000 to the investor.

Two parties can enter into a forward agreement such that Party A will buy this T-bill from Party B at a price of $985 30 days from now. This will be a forward contract.

When the market interest rates increase, the discount rate will increase, leading to a fall in the T-bill price. Since the long is required to purchase the bond, a decrease in price will be a loss for him and profit for the short. Similarly, when the price increases, it will be a profit for the long and loss for the short.

In case of coupon paying bonds, the price in the forward contract will be stated in terms of yield to maturity as on the settlement date. The yield excludes the accrued interest. There are separate provisions for the risk of default, and other features such as an embedded option.

These forward contracts can be on individual bonds as well as portfolio of bonds.

Forward Contracts on Zero-coupon and Coupon Bonds

The London Interbank Offered Rate (“LIBOR”) and the Euro Interbank Offered Rate (“EURIBOR”) are benchmark reference rates fundamental to the operation of both UK and international financial markets, including markets in interest rate derivatives contracts.

LIBOR and EURIBOR are by far the most prevalent benchmark reference rates used in euro, US dollar and sterling over the counter (“OTC”) interest rate derivatives contracts and exchange traded interest rate contracts.

LIBOR and EURIBOR are used to determine payments made under both OTC interest rate derivatives contracts and exchange traded interest rate contracts by a wide range of counterparties including small businesses, large financial institutions and public authorities.  Benchmark reference rates such as LIBOR and EURIBOR also affect payments made under a wide range of other contracts including loans and mortgages.

LIBOR is published on behalf of  the British Bankers’ Association (“BBA”) and EURIBOR is published on behalf of the European Banking Federation (“EBF”).

LIBOR (in each relevant currency) and EURIBOR are set by reference to the assessment of the interbank market made by a number of banks.  Those banks are selected by the BBA and EBF and each bank contributes rate submissions each day.

These submissions are not averages of the relevant banks’ transacted rates on a given day.  Rather, both LIBOR and EURIBOR require contributing banks to exercise their subjective judgement in evaluating the rates at which money may be available in the interbank market in determining their submissions.

Both LIBOR and EURIBOR have definitions, which set out the nature of the judgement required from the contributing banks in determining their submissions:
<ol>
	<li>Since 1998, the LIBOR definition published by the BBA has been as follows: “The rate at which an individual contributor panel bank could borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size just prior to 11:00 London time”;</li>
	<li>EURIBOR is defined by the EBF as “The rate at which euro interbank term deposits are being offered within the EMU zone by one prime bank to another at 11:00 am Brussels time.”</li>
</ol>
The definitions are therefore different; LIBOR focusing on the contributor bank itself and EURIBOR making reference to a hypothetical prime bank.  However each definition requires submissions related to funding from the contributing banks.  The definitions do not allow for consideration of factors unrelated to borrowing or lending in the interbank market.

The LIBOR and EURIBOR definitions are published and available to all participants in both UK and international financial markets.

<em>Source: Information extracted from Financial Services Authority's Final Notice to Barclay's bank for Libor Scandal.</em>

How are LIBOR and EURIBOR Calculated?

Forward Rate Agreements (FRA’s) are similar to <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contracts</a> where one party agrees to borrow or lend a certain amount of money at a fixed rate on a pre-specified future date.

For example, two parties can enter into an agreement to borrow $1 million after 60 days for a period of 90 days, at say 5%. This means that the settlement date is after 60 days, on which date the money will be borrowed/lent for a period of 90 days.

The party that is borrowing money under the FRA has a long position, and the party that is lending money has a short position in the FRA.

FRA contracts are usually cash-settled, that is, the money is not actually lent or borrowed. Instead, the forward rate specified in the FRA is compared with the current LIBOR rate. If the current LIBOR is greater that the FRA rate, then the long is effectively able to borrow at a below market rate. The long will therefore receive a payment based on the difference between the two rates. If, however, the current LIBOR was lower than the FRA rate, then long will make a payment to the short. The payment ends up compensating for any change in interest rates since the contract date.

FRAs can be based on different periods, and are quoted in terms of months to settlement date and the months to completion of interest period. In our example, the settlement date is after 60 days (2 months), and then there is an interest period of 90 days (3 months). The contract will complete after a total of 2+3 = 5 months. This FRA will be referred to as 2x5 FRA.

FRAs are generally used to lock in an interest rate for transactions that will take place in the future. For example, a bank that plans to issue or roll over certificates of deposit, but anticipates that interest rates are headed upward, can lock in today’s rate by purchasing FRA. If rates do rise, then the payment received on the FRA should offset the increased interest cost on the CDs. If rates fall, the bank pays out.

The above example demonstrated how FRAs are used to lock in an interest rate or debt cost. FRA’s can also be used to lock in the price of a short-term security to be bought or sold in the near future.
<ul>
	<li>If the investment is being purchased, you can hedge the risk that interest rates may fall (which would increase the price of the investment) by selling the FRA.</li>
	<li>If the investment is being sold, you can hedge against the risk of rates rising (which would depress the sales price of the security) by buying the FRA.</li>
</ul>
<strong>Calculating FRA Payments</strong>

Let’s take an example to understand how payments in an FRA are calculated.

Consider a 3x6 FRA on a notional principle amount of $1million. The FRA rate is 6%. The FRA settlement date is after 3 months (90 days) and the settlement is based on a 90 day LIBOR.

Assume that on the settlement date, the actual 90-day LIBOR is 8%. This means that the long is able to borrow at a rate of 6% under the FRA, which is 2% less than the market rate. This is a saving of:

= 1,000,000 * 2% *90/360 = $5,000

This is the interest that the long would save by using the FRA. Since the settlement is happening today, the payment will be equal to the present value of these savings. The discount rate will be the current LIBOR rate.

FRA Payment = $5,000/(1+0.08)^(90/360) = $4,904.72

Forward Rate Agreements and Calculating FRA Payments

A currency <a title="Introduction to Forward Contracts" href="https://financetrain.com/introduction-to-forward-contracts/">forward contract</a> is an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.

By using a currency forward contract, the parties are able to effectively lock-in the exchange rate for a future transaction.

The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations.

The currency forward contracts can be both deliverable or cash settled. In case of cash settled currency forwards the payment is made by the party who is at loss to the party who is at gain.

Let’s take an example to understand how a currency forward contract works.

Assume a US exporter who is expecting to receive a payment of EUR 10million after 3 months. Since he will need to convert these euros into US dollar, there is exchange rate risk involved. The exporter enters into a cash-settled currency forward contract to exchange 10 million euros into US dollars after 3 months at a fixed exchange rate of 1EUR = 1.2 USD. That means he will be able to exchange his 10 million euros for 12 million US dollars after 3 months.

Now assume that the actual exchange rate after 3 months is 1 EUR = 1.18 USD.

If there were no forward contract, the exporter would have received USD 11.8 million by exchanging EUR 10 million at the market exchange rate.

Since there is a forward contract, the exporter should receive USD 12 million at the rate of 1 EUR = 1.2 USD.

Under the terms of the contract, the counterparty must compensate the exporter by making a payment equivalent to the difference between the fixed rate and the current exchange rate to the exporter. In this case, the exporter will receive USD 0.2 million from the counterparty as cash settlement.

Note that if the US dollar has strengthened instead of weakening, then the exporter would have made the payment to the counterparty.

How Currency Forward Contracts Work?

This frontmatter description will appear below the title

Forward Markets and Contracts

Course Resources

Lessons

Data Science in Finance: 9-Book Bundle

What's Included:

Free Guides - Getting Started with R and Python

Data Science in Finance: 9-Book Bundle

What's Included: