How is a Forward Contract Settled?

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:

• If the price of the asset is above the forward price, then long receives the payment.
• If the price of the asset is below the forward price, then the short will receive the payment.

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.