Types of Forward Contract

Forwards contracts in India are broadly governed by the Forward Contracts (Regulation) Act, 1952. According to this act, forward contracts are of the following five major categories:

  1. Equity Forward Contract
  2. Bond Forward Contract
  3. Interest-rate Forward Contracts
  4. Currency Forward Contracts
  5. Commodity Forward Contract

 

Equity Forward Contract

An equity forward is a contract for the purchase of an individual stock, a stock portfolio, or a stock index at some future date.

An equity forward on an individual stock allows an investor to sell his or her stock at some future date at a guaranteed price.

If that guaranteed price is below the market price, the investor will still receive the guaranteed price.

If the market price is above the guaranteed price, the investor will only receive the guaranteed price and not be able to participate in any market increase above that price.

For example, a client owns IBN at 100 and wants to sell IBN stock in six months to raise some cash. The client cap enters into an equity forward in which he will receive a price of $125

  1. If the price remains at or below $125, the client will receive $125 per share in six months.
  2. If the stock price is at $130, the client will still have to deliver the shares to the counterparty and will only receive $125 per share, losing $5 on the transaction.

Forward contracts on a stock portfolio work the same way as on an individual basis. Instead of entering into separate contracts for each of the individual securities in the portfolio, which could be costly in terms of fees, the manager can give a list of securities in the portfolio to the dealer, who will develop a quote of the price for which the dealer would purchase the securities at a future date.

Bond Forward Contract

The basic characteristics of a forward contract on a bond are very much like those of equity. A bond pays a coupon similar to equity paying a dividend.

The differences are:

  1. Bonds mature; this means that contracts must also mature before the maturity date.
  2. Bonds can have calls and convertibility.
  3. Bonds have a default risk, which means the contract must include remedies for this risk in case it occurs.

Forward contracts can be on an individual issue as well as on a portfolio of bonds or on a bond index.

For zero-coupon bonds like a T-bill, a forward contract has one party agreeing to buy the T-bill at a later date, but before its maturity, at a price that is agreed to at the time the contract is made.

For example, A 180 day T-bill is selling at 3.5%. The par of a $1 par value, therefore, would equal 1 – .035(180/360) = $ 0.9825.

If the bond is held to maturity it will pay the investor $1. The 360 days in the above formula is a market convention for the number of days in a year.

Interest-rate Forward Contracts

Interest-rate forward contracts involve the future sale or purchase of debt instruments. Interest-rate forward contracts specify the actual debt instrument that will be delivered, the amount of the debt instrument be delivered, the price (interest rate) on the debt instrument when it delivered, and the date of when the delivery is to take place.

An example of an interest-rate forward contract might be if First Regional Bank agreed to sell $2 million of US Treasury Bonds that mature in 2020 with a 6% coupon rate to Second Nation Bank at a future date at a specified price that would yield that same interest rate of 6% that they yield today.

In this example, Second Regional Bank holds a long position since it has agreed to purchase the bonds and First Regional Bank holds a short position since it has agreed to sell the bonds.

Currency Forward Contracts

Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future.

If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect “locked-in” the exchange rate payment amount.

By locking into a forward contract to sell a currency, the seller sets a future exchange rate with no upfront cost.

For example, a U.S. exporter signs a contract today to sell hardware to a French importer. The terms of the contract require the importer to pay euros in six months’ time.

The exporter now has a known euro receivable. Over the next six months, the dollar value of the euro receivable will rise or fall depending on fluctuations in the exchange rate.

To mitigate his uncertainty about the direction of the exchange rate, the exporter may elect to lock in the rate at which he will sell the euros and buy dollars in six months.

To accomplish this, he hedges the euro receivable by locking in a forward.

This arrangement leaves the exporter fully protected should the currency depreciate below the contract level.

However, he gives up all benefits if the currency appreciates. In fact, the seller of a forward rate faces unlimited costs should the currency appreciate.

This is a major drawback for many companies that consider this to be the true cost of a forward contract hedge.

For companies that consider this to be only an opportunity cost, this aspect of a forward is an acceptable “cost”.

For this reason, forwards are one of the least forgiving hedging instruments because they require the buyer to accurately estimate the future value of the exposure amount.

Like other future and forward contracts, foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world.

Foreign currency forwards contracts may have different contract sizes, time periods, and settlement procedures than futures contracts.

Foreign currency forwards contracts are considered over-the-counter (OTC) because there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.

For example, Corporation A has a foreign sub in Italy that will be sending it 10 million euros in six months. Corp. A will need to swap the euro for the euros it will be receiving from the sub.

In other words, Corp. A is long euros [and short dollars is short dollars because it will need to purchase them in the near future. Corp.

A can wait six months and see what happens in the currency markets or enter into a currency forward contract. To accomplish this, Corp. A can short the forward contract, or euro, and go long the dollar.

Corp. A goes to Citigroup and receives a quote of .935 in six months. This allows Corp. A to buy dollars and sell euros.

Now Corp. A will be able to turn its 10 million euros into 10 million x .935 = 935,000 dollars in six months.

Six months from now if rates are at .91, Corp. A will be ecstatic because it will have realized a higher exchange rate. If the rate has increased to k95, Corp.

A would still receive the .935 it originally contracts to receive from Citigroup, but in this case, Corp. A will not have received the benefit of a more favorable exchange rate.

Commodity Forward Contract

A forward contract is an agreement between two parties – the seller and the buyer – for the delivery of a certain quality and quantity of a commodity at a specified time and for a specified price.

Farmers often use forward contracts as hedges against falling prices. Such contracts are legally binding and very difficult to break.

If at the time of the contract’s expiration, the price stipulated in the contract matches the going rate, the contract has no value.

If the average price of the commodity has risen over the length of the contract to a level exceeding the contract price, the contract becomes valuable to the purchaser.

If the average price of the commodity has fallen, the contract helps the seller. In forward contracts, whenever the price of the contracted commodity changes, one of the parties to the contract gains while the other loses.

Appreciation benefits the buyer while depreciation benefits the seller.

Pricing of Commodity Forward

Pricing of forwarding contracts, be it financial or commodity forward contracts, is simpler than futures contracts.

In a forward contract, there is only one payment/receipt at the end of the maturity period, while in the case of futures there are initial margin and mark-to-market payments and receipts.

As mark-to-market margin payment and receipt during the life of a contract cannot be modeled exante, commodity forward prices are used as futures prices.

It is important to understand the difference between the use of commodities as consumption assets and investment assets for modeling forward contract prices.

Commodities, those that are primarily used for consumption are known as consumption assets.

Investment assets are those assets which are primarily held for investment purpose and do not have any other use.

All financial assets like shares, bonds, interest rate, and exchange rate are investment assets. Crude oil, wheat, sugar, electricity, etc., are primarily held for consumption.

To understand how a commodity forward contract can be priced, consider a simple example:

On January 1, Raja realizes that he will need 20 MT of rice July 1. Raja has three options to get this rice on July 1.

Alternative 1: Not do anything until July 1, and purchase 20MT of rice on July 1 at the prevailing market price P1.

Alternative 2: On January 1, enter into a forward contract to buy 20MT of rice on July 1 at a forward price

Alternative 3: Buy 20MT of rice on January 1 at the price of p0, which is the price of rice in the market today, and keep it stored in a warehouse. This price p0 is also known as the spot price at time 0.

Among these alternatives, the first alternative is risky because the price of rice on July 1 is not known on January 1, whereas this price risk has been eliminated in alternatives 2 and 3.

In alternative 2, the forward price fo, which is the price at which the rice will be bought on July 1, is decided today and hence this price is known with certainty.

In alternative 3, the rice is being bought today at the spot price, which is also known with certainty.

However, buying rice on January 1 at the spot price requires that the rice be stored in the warehouse until July 1, and this would mean incurring storage costs.

Thus, the price that is paid today should be adjusted for the storage costs when considering the cost of using this strategy.

Since alternatives 2 and 3 do not result in any risk, both of them must result in the same cost to the buyer,

fo = Po + C

where,

f0 = Forward price

p0 = current spot price of the underlying commodity

c = Cost of carrying the commodity from the day on which the contract is entered into until the delivery date of the forward contract.

The cost of carrying includes:

  1. The actual cost of storage in the warehouse, including warehouse rent.
  2. The expenses in connection with the storage, such as freight and insurance.
  3. The opportunity cost of funds invested in buying the goods.

Assume that the spot price on January 1 is INR 22 per kg, and buying 20MT of rice will require an investment of 20 x 22 x 1000 = INR 4,40,000.

This amount will be needed for investment today. On the other hand, if the futures price is INR 25 per kg, the amount of 25 x 20 x 1000 = INR 5,00,000 will have to be paid only on July 1.

The amount of INR 4,40,000 can be invested today in other financial instruments that can offer a positive return.

The rate at which the amount can be invested today at no risk is known as the opportunity cost, and this cost should also be taken into consideration in the cost of carrying.

Usually, the cost of carrying is expressed as a percentage of the spot price.

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