Forward Contract

Be wary then; best safety lies in fear

(Hamlet -- Act I, Sc. III)

Forward Contract:

A forward contract is an agreement between a buyer and a seller in which buyer agrees to buy and seller agrees to sell a certain commodity or security at a certain fixed price in future. The security that is being traded is called as the underlying. Thus, the difference between a forward contract and any ordinary contract is that the actual transaction takes place at some time in future, not immediately. The parties involved in a forward contract are often private parties for e.g. Two financial institutions or a financial institution and its client. There is no involvment from any Exchange in it.

Example: A construction company may enter into a forward contract with a steel manufacturer on 15^th March 2009 to buy a 1000 tons of steel at the price of Rs 1500/tonne on 15^th Dec 2009. It may so happen that the 1000 tons of steel may not even have been produced yet. But there is a contract binding the two parties and the transaction will take place in Dec for sure. By entering into such a contract, both the parties try to protect themselves from the abnormal movements in steel prices. Thus the construction company protects itself from the risk that in Dec, steel prices could be more than 1500/tonne. Conversely, the steel manufacturer protects himself from the risk that in Dec, the steel prices will be lower than 1500/tonne. By doing so, each party is willing to let go of the profit in the event when the prices slide in their favor.

Exchange traded markets and OTCs:

Exchanges have traditionally served as a middleman between two parties wanting to trade. Derivative exchanges have existed for a long time. In 1848, The Chicago board of Trade (CBOT) was established to help farmers and merchants trade for crops and grains. Its initial purpose was to just bring these two parties together and ensure a good quality of grains. Later, such future-type contracts were developed on these grains. (Note: Futures are similar to forwards with small variance which can be neglected for now) People started becoming more interested in trading these contracts rather than trading the actual commodity. Later, in 1919 another derivatives exchange called Chicago Mercantile Exchange (CME) was established.

However, exchanges arenot the only place where people can trade. There is another mechanism called Over The Counter market (OTCs). In this, trading is done over the phone. There is no physical place such as an exchange. Each party may communicate with eachother over telephone lines. These conversations are recorded for authenticity purposes. Trades done in OTCs are much larger than those in Exchange traded markets. The main advantage of OTCs is there is no transaction costs involved with the trading. Also, the terms of the contract can be privately agreed upon by the parties involved rather than being laid down by the exchange. However, the main disadvantage of OTCs is that either of the parties may default or purposfully chose not to honor the contract. Forward contracts are traded in such OTCs.

Spot price and forward price:

In a forward contract mentioned in the example above, the price of steel on 15^th March is known as the spot price and its price on 15^th Dec is known as its forward price. Thus, spot price is the price of the commodity on any given day. Forward price is its execution price. There is a unique relation between these two prices. Forward price is derived from spot price. As delivery approaches, the future price converges to the spot price of the contract. On the day of delivery, the future price will be equal (or almost equal to) the spot price. If forward price is above spot price on day of delivery, traders have a clear opportunity of doing arbitrage as:

1. Buy the asset from market at spot price.
2. Enter into a forward contract to sell the asset (go short)
3. Make the delivery of asset on day of delivery at forward price.

The difference is pocketed thus. Similarly, one can argue for the reverse case.

Terms of a forward contract:

While entering into a forward contract, its becomes obligatory for each party involved to ensure that there stays no tinge of ambiguity in the terms and conditions of the contract. Therefore, following things have to be well defined in any forward contract:-

1. Delivery terms and location
2. Quality specification of the asset
3. Payment methods
4. Dispute resolution procedure
   
5. Contract cancellation procedure
6. How to close the positions. (Since one cannot backout of a forward contract, if one still wants to cancel the contract, he can take an opposite position of same asset on another contract, thus offsetting his previous position)
   
   

Pricing a forward contract:

As explained above, as the delivery date approaches, the forward price should converge to the spot price. However, at the time of writing a forward contract, how does one determine what should be the fair price say 10 months down the line, of that asset. So in our example above, if price of a tonne of steel on 15^th March was Rs. 1300, how do we come to the conclusion that forward price for 15^th Dec should be Rs. 1500. As intuitive as it may seem, forward prices are not determined using any highly sophisticated predictive modelling technique or something. Neither are they based upon the “mutual intuition” of both the parties involved. They are often calculated taking into account the current price (spot price) and the price of “maintaining” the asset for the period of the forward contract. This maintainance encompasses different kinds of consts like:-

1. Transaction charges: Any broker commisions, administrative fees etc.
   
2. Transportation charges at the time of delivering the asset and also when transporting it to the sellers storage facility initially.
3. Rent paid to rent a storage facility if needed.
4. Insurance on the asset for the time its with the seller.
5. The cost of money: In order to deliver steel, the manufacturer might have to take some loan over which he has to pay interest. Interest is also accrued by other posible loans taken for storage etc.
   

This list is not exhaustive. There are multiple other costs involved based on the nature of the asset. So the forward price is: spot price (1300) + Maintainance costs (200) = 1500.

Hedging using forwards:

Lets us consider an example of FOREX markets for illustrating this. A US company X has bought some goods from a Indian supplier for which it knows it has to pay Rs. 100000 after one year. Let current dollor/rupee FX rate be 1/47 i.e. $1 = Rs. 47. However, the company fears the dollor/rupee FX rate might increase i.e. It might have to pay more number of dollars per rupee. So to tackle this uncertainity, it will take a long position on a forward contract with asset as Indian Rupee. (Note: Going short means selling, going long means buying). So it may sign a contract to buy Rs 100000 after one year @ Rs 47.1. So now, it has hedged its position buy buying Rupees at a fixed rate which is lower than its expectation of the FX rate.

Similarly, if a US supplier supplies goods to an Indian company and it expects to receive Rs.100000 after one year, then it may lock its position by going short on rupee i.e. By selling the rupee at a fixed rate of say Rs. 46.92 for every dollor. It will do this because it fears that dollor might weaken against rupee.

Note that primary purpose of hedging is to remove/reduce risk from a transaction. It is not aimed at making profit. Thus, the above companies could have possibly earned more profit if the FX rates had slid in their favor a year later. However, things could also have gone other way round and they could have suffered losses. So to avoid these extreme scenarios, transactions with big turnovers are often locked using forward contracts.