A forward contract 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:
- 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.