A forward contract is usually traded between two financial institutions or between a financial institution and one of its clients.
One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same date for the same price.
The pay-off from a forward position at maturity depends on the relationship between the delivery price (K) and the underlying price (Sr) at that time.
The pay-off from a long position in a forward contract on one unit of an asset is equal to the excess of the underlying price on maturity over the dele very price.
Clearly, if the spot price on maturity date is more than the delivery price, the buyer stands to gain, and if the spot price is less than it, he stands to lose.
For the party with a short position, the pay-off would be exactly opposite to that of the long position. Symbolically, the pay-off from a forward contract on one unit of an asset can be given as:
- For a long position, this pay-off is: fT = ST – K
- For a short position, it is: fT = K – ST
K = Delivery Price
St = Price of the asset at Contract Maturity
These pay-offs can be positive or negative. Because it costs nothing to enter into a forward contract, the pay-off from the contract is also the trader’s total gain or loss from the contract.