Monday, May 4, 2015

Forward contract

In finance, forward contract - simply forward îs non-standardized contract between two parties to buy - sell asset at specified future time at price agreed today, This îs în contrast to spot contract, which îs agreement to buy - sell asset today, It costs nothing to enter forward contract, The party agreeing to buy underlying asset în future assumes long position, & party agreeing to sell asset în future assumes short position, The price agreed upon îs called delivery price, which îs equal to forward price at time contract îs entered into,

The price of underlying instrument, în whatever form, îs paid before control of instrument changes, This îs one of many forms of buy/sell orders where time of trade îs not time where securities themselves are exchanged,

The forward price of such contract îs commonly contrasted with spot price, which îs price at which asset changes hands on spot date, The difference between spot & forward price îs forward premium - forward discount, generally considered în form of profit, - loss, by purchasing party,

Forwards, like other derivative securities, can be used to hedge risk (typically currency - exchange rate risk), as means of speculation, - to allow party to take advantage of quality of underlying instrument which îs time-sensitive,

A closely related contract îs futures contract; they differ în certain respects, Forward contracts are very similar to futures contracts, except they are not exchange-traded, - defined on standardized assets, Forwards also typically have no interim partial settlements - "true-ups" în margin requirements like futures – such that parties do not exchange additional property securing party at gain & entire unrealized gain - loss builds up while contract îs open, However, being traded OTC, forward contracts specification can be customized & may include mark-to-market & daily margining, Hence, forward contract arrangement might call for loss party to pledge collateral - additional collateral to better secure party at gain,


Payoffs

The value of forward position at maturity depends on relationship between delivery price (K) & underlying price (ST) at that time,

For long position this payoff is: fT = ST − K
For short position, it is: fT = K − ST
How forward contract works

Suppose that Bob wants to buy house year from now, At same time, suppose that Andy currently owns $100,000 house that he wishes to sell year from now, Both parties could enter into forward contract with each other, Suppose that they both agree on sale price în one year's time of $104,000 (more below on why sale price should be this amount), Andy & Bob have entered into forward contract, Bob, because he îs buying underlying, îs said to have entered long forward contract, Conversely, Andy will have short forward contract,

At end of one year, suppose that current market valuation of Andy's house îs $110,000, Then, because Andy îs obliged to sell to Bob for only $104,000, Bob will make profit of $6,000, To see why this îs so, one needs only to recognize that Bob can buy from Andy for $104,000 & immediately sell to market for $110,000, Bob has made difference în profit, In contrast, Andy has made potential loss of $6,000, & actual profit of $4,000,

The similar situation works among currency forwards, where one party opens forward contract to buy - sell currency (ex, contract to buy Canadian dollars) to expire/settle at future date, as they do not wish to be exposed to exchange rate/currency risk over period of time, As exchange rate between U,S, dollars & Canadian dollars fluctuates between trade date & earlier of date at which contract îs closed - expiration date, one party gains & counterparty loses as one currency strengthens against other, Sometimes, buy forward îs opened because investor will actually need Canadian dollars at future date such as to pay debt owed that îs denominated în Canadian dollars, Other times, party opening forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on currency, expecting exchange rate to move favorably to generate gain on closing contract,

In currency forward, notional amounts of currencies are specified (ex: contract to buy $100 million Canadian dollars equivalent to, say $114,4 million USD at current rate—these two amounts are called notional amount(s)), While notional amount - reference amount may be large number, cost - margin requirement to command - open such contract îs considerably less than that amount, which refers to leverage created, which îs typical în derivative contracts,

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