Basic derivatives contracts are forward contracts, futures contracts, call options and put options. These are contracts between two parties with a payoff in a future date and the payoff is tied to the price of an underlying asset (hence the name derivative). Here are some natural questions. What are derivatives? How do they work? What do they cost? Why do investors or firms want to enter into such a contract? If you enter into such a contract, what are the obligations and benefits? This post is a brief introduction of forward contracts. In this post, we explain the basic features of forward contracts. In the next post, we discuss the prices of forward contracts.
Forward contracts – basic features
Forward contracts allow firms or investors to lock into a price today for a purchase or sale of an asset that will take place at some point in the future. Thus forward contracts are a basic financial risk management tool. A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. Each forward contract will specify the following:
- The underlying asset.
- The expiration date.
- The forward price.
- The contractual obligation.
The underlying asset of a forward contract is the financial asset or commodity the seller must deliver to the buyer. A forward contract will specify the quantity and the type of assets to be transacted. The assets that are transacted in the future can be financial assets (e.g. stock, currencies, and interest rates) or commodities (e.g. gold, corn and natural gas). The expiration date is the time at which the contract is settled. The forward price is the price (per unit of the asset) that is agreed upon today by both parties of the contract to transact in the future (i.e. on the expiration date). On the expiration date, the buyer pays the seller the forward price and the seller delivers the asset to the buyer. The last bullet point refers to the obligation that the buyer must buy and the seller must sell on the date of settlement even if the price movement means a loss to one of the parties in the contract.
The party who commits to buying the asset on the delivery date is said to take a long position (or entering into a long forward). The party who commits to selling the asset on the delivery date is said to take a short position (or entering into a short forward). The party in the long position is said to “buy” a contract and the party in the short position is said to “sell” a contract.
Generally the long position is the party that makes money when the price of the asset goes up and the short position is the party that makes money when the price goes down. Note that the long position agrees to buy the asset at pre-agreed upon fixed price. So the long position profits when prices rise. The payoff to a forward contract is the value of the position at expiration. The following shows the payoff.
Payoff to long forward = spot price at expiration – forward price
Payoff to short position = forward price – spot price at expiration
For a forward contract, the settlement can take place on a delivery basis (i.e. there is a physical transfer of the asset) or on a cash basis. If settlement is on a cash basis, the long position will receive the payoff to the long position (which can be positive or negative) and the short position will receive the payoff to the short position (which could be positive or negative). For an illustration of how this works, see the example discussed below.
Futures versus forwards
Futures contracts are similar to forward contracts in that a futures contract is also a contract between two parties to buy or sell an asset at a specified price on a future date and that both parties have the obligation to do so on the delivery date. But there are important institutional and pricing differences.
For examples, futures contracts are exchange traded while forward contracts are traded over the counter. Thus futures contracts tend to be standardized and forward contracts are customized contracts. The futures exchange standardizes the types of contracts that may be traded. For example, it establishes contract size, the acceptable grade of commodity (if it is a commodity exchange), contract delivery dates and so on. On the other hand, forward contracts can be tailored to meet the unique or unusual requirements of the party seeking the contract.
Futures contracts also have the advantage of liquidity and a reduced level of credit risk. Standardization means that many traders will concentrate on a small set of contracts. Thus trading in futures contracts can be highly liquid. Many futures contracts can be liquidated through a broker rather than directly with the counter party of the contract. Another difference between futures and forwards is that the exchange requires the parties in a futures contract to settle any gains or losses on the contract on a daily basis (this is called the marking to market). The daily marking to market required by the exchange amounts to a guarantee of performance of the parties in a contract. Thus costly credit checks on the counter party of a futures contract are not necessary. On the other hand, for a forward contract, no money changes hand until the delivery date. So credit risk, the risk that the other trader will not perform, can be a much greater concern for traders entering into forward contracts.
Forward contracts – an example
To see how forward contracts work and how they might be used to hedge risk, let’s look at an example. Suppose that a corn producer has 2 million bushels of corn to sell in 6 months. The corn producer is concerned about a substantial price decline of corn. A food company that uses corn has the opposite risk in that its profit will suffer due to a substantial price increase in corn.
Both parties can offset this risk if they enter into a forward contract that obligates the corn producer to sell 2 million of bushels of corn in 6 months to the corn user at the forward price of $3.85 per bushel with settlement on a cash basis. The corn producer is the short position in this contract and the food company (the corn user) is the long position. The corn producer is obligated to sell 2 million of bushels of corn to the corn user at the agreed upon price of $3.85 per bushel. The corn user is obligated to buy the corn from the producer at $3.85 per bushel.
There is no cash changing hand between the two parties at the time the contract is made. A forward contract is in essence a purchase or sale of an asset such that the delivery of the asset is deferred. The money is exchanged at the time of settlement but the price is set ahead of time when the contract is made. Such a contract locks in the price to be paid or received for the delivery of the asset or commodity in question. The effect is that the contract protects each party from future price fluctuation. Let’s look at a numerical example. After 6 months, considering the following 3 possibilities:
- There is essentially no change in corn prices.
- The spot price is lower than the forward price, say $3.35 per bushel.
- The spot price is higher than the forward price, say $4.35 per bushel.
In the first case, there is no exchange of cash between the corner producer and the financial institution. If there is only a small difference between the spot price and the forward price, there is essentially no risk to either party.
In the second case, the payoff per bushel to the short position is $3.85 – $3.35 = $0.50. Thus the corn user owes the corn producer $1,000,000. Thus the corn producer is protected from a price decline.
In the third case, the payoff per bushel to the short position is $3.85 – $4.35 = -$0.50. Thus the corn producer owes the corn user $1,000,000. Here, the corner user is protected from a price upswing.
The above example shows that forward contracts (or futures contracts) can be used to hedge price risk. A previous post gives an example of how forward contracts can be used to hedge exchange rate risk for exporter (or investor investing abroad). These two examples illustrate one useful feature of forward contracts. Corporations use forward contracts is to offset their risk exposures and limit themselves from any fluctuations in price. When a company knows that it will have a need to purchase an asset or commodity in the future, it can take a long position in a contract to hedge its position. When a company knows that it will have a need to sell an asset or commodity in the future, it can take a long position in a contract to hedge its position. Forward contracts can be very useful in limiting the price risk exposure faced by a corporation. The main advantage of using forward contracts is that it removes the uncertainty about the future price of an asset or commodity, thus eliminating the uncertainty in profit due to unpredictable fluctuation in prices.
In the next post, we discuss the pricing of forward contracts.