1Introduction to Forward Derivative Contracts

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1Introduction to Forward Derivative Contracts
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2Forward Derivative Contract Defined

• Defn A forward contract is a formal agreement
  between two parties to exchange specified assets
  over specified future time periods (see example).
• That it is a contract suggests that it is a
  legally binding agreement. Time may reveal that
  you would have been better off, ex-post, if you
  had not signed the contract. And so a means of
  enforcement may be necessary as a precautionary
  measure.

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3Spot Contracts (Simultaneity)

• An alternative is a spot agreement. Spot
  agreements are sometimes legally binding, in
  which case they are spot contracts.
• Defn A spot agreement/contract is an
  agreement/contract between two parties to
  exchange an asset immediately (or within a very
  short period of time from now) at a certain price
  (usually the prevailing spot price).
• Examples include trades of used cars, pens of
  cattle, and items in WalMart. The law may turn a
  spot agreement into a formal contract by, for
  example, obliging parties to the trade to nullify
  the agreement if one party changes its mind
  within a specified period of time subsequent to
  the spot trade. Financing contracts may also be
  tied to a spot trade.

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4Forward vs. Spot Contracts

• Forward agreements are usually more formal in
  nature than spot agreements. This is because
  they are generally more complicated and risky
  than spot agreements. Specifically,
• there should be agreement on what to deliver and
  when. If you are obliged to deliver 100 tons of
  corn in one month then you will likely deliver
  the lowest quality corn available on the spot
  market. Quality issues arise more often in
  commodity markets than in security markets, but
  related issues are common in bond markets because
  bond derivatives may cover several types of
  bonds.
• Depending upon intervening price movements,
  forward agreements may acquire positive/negative
  value. As a precaution, it may be best to have a
  legal means of enforcement.

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5Examples of Forward Contracts

• Packerland Packing Co. Contract.
• An agreement to sell 4,000 oz of gold _at_290/oz on
  1/29/2001.
• An agreement to buy 2,000,000 ECU _at_ 1.1/ on
  9/1/2001.
• An agreement to earn 5 interest compounded
  quarterly on 1,000,000 for 1 year starting
  September 1st 2000.
• An agreement to sell 2,000,000 Bu wheat _at_
  3.35/Bu on February 2nd 2000.

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6OTC Nature of Forward Contracts

• The contract is generally over-the -counter
  (OTC). i.e., the deal is agreed upon in an
  environment whereby the parties are not
  constrained to pre-determined contract
  specifications. The parties can write a contract
  to suit their particular needs provided it does
  not violate regulatory constraints.
• Normally when a forward contract is first written
  the forward price is chosen so that the contract
  initial value is 0. That is, there is no need
  to buy ones way into a contract when it is first
  written. It is for convenience that the initial
  value is generally 0. Why not 10 (or - 10)?
  Then the forward price would likely differ from
  what one might expect it to be. Then one may
  think of the forward contract as an agreement to
  sell forward at a reasonable price plus a loan
  agreement.

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7Issues when Writing Forward Contracts

• The specifications of a forward contract can be
  quite complicated because the purchaser wants to
  be clear about what is delivered. Issues that
  may arise include the ability to measure quality,
  the cost of measuring quality, who measures it,
  transportation, and delivery points.
• While flexible in term of their content, once
  entered into forward contracts tend to be
  inflexible. Both parties must agree to any
  change. This is a very important issue. There
  are many reasons why a party might wish to exit a
  forward contract during its duration. Market
  conditions may change.

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8Issues when Writing Forward Contracts, Contd

• A firm may learn more about future
  production/financing activities. It may be
  difficult/costly to extricate oneself from such
  an agreement (time costs, payment of
  compensation, legal costs).
• Among all forward contracts, foreign exchange
  forwards are generally easiest to get out of
  because they are so liquid and because
  specifications often do not differ much across
  contracts. In fact, it is often possible to
  exit the contract by entering a second contract
  that reverses your previous position, e.g., sell
  forward to offset a situation where you had
  bought forward.

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9Forward Price

• Defn The time to maturity of a contract is the
  time until delivery.
• For example, if it is now time t and delivery
  (maturity) is at time T, then the time to
  maturity is T - t.
• Defn The forward price FT,t at time t for a
  forward contract with maturity at time T is the
  delivery price at time T which is guaranteed in
  the contract.

t
T
Now
Exchange amount FT,t for the commodity
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10The Long and the Short of a Contract

• There are generally two parties to a forward
  contract. The party that agrees to buy forward
  (i.e., take delivery) is said to assume the long
  position, and the party that agrees to sell
  forward (i.e., deliver) is said to assume the
  short position. As a mnemonic, s is for sell and
  for short.
• Example On January 12th 2000 a firm agrees to
  buy 10,000,000 Euros at 1.05/ in 90 days.
  Here, the firm is taking a long position in the
  forwards market. At maturity, in 90 days, let
  the exchange rate on the spot market be 1.03/.
  The firm pays 10.5 mill., and takes delivery of
  1 mill. Euros. But these are worth 10.3 mill.
  in the spot market, and so the long position
  incurs a loss of 0.2 mill.

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11The Long and the Short of a Contract, Contd

• The firm made a loss on being long because the
  spot price fell after the agreement was entered
  into. Ex-post, the firm might like to reneged on
  the agreement, but it couldnt.
• Had the spot price moved up, the long firm would
  profit. E.g., if the spot price at maturity were
  1.07/ then the long would book a gain of 0.2
  mill.
• Note the symmetry
• for every long position that is assumed, some
  party always assumes a short position
• for every short position that is assumed, some
  party always assumes a long position
• apart from transactions costs, accounting gains
  and losses are zero sum. As in gambling, what
  someone gains someone loses.

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12Comments on Purposes of Forwards

• If all that occurs is a wealth transfer, then why
  the big deal? Shouldnt society view forwards as
  just gambling?
• Briefly, there are two responses.
• Forwards allow firms to manage risk, or trade
  risk so that those in a better position to cope
  with the possible consequences of risk are those
  that actually assume it.
• Risk markets in general reveal (free) information
  to others. To that extent, risk markets generate
  a positive externality. This information allows
  firms to plan better and so be more efficient in
  using scarce resources.
• Defn A positive externality occurs to party B if
  actions taken by party A in pursuit of private
  interests improve the welfare of B even though B
  does not reward A. (von Hayek intangibles)

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13Position Diagram

• We now graph the relation between spot price at
  maturity and profit in the ForEx example.

Profit from Position
0.2m
1.07/
1.03/
0
Spot Price at Maturity
1.05/
- 0.2m
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14Position Diagram, Contd

• Note that profit in the long position is
  increasing in the underlying variable. You
  commit to buy now at a fixed price. If price
  rises before maturity, then you can take delivery
  at maturity and sell at a profit. Alternatively,
  you can consume the item delivered and you paid a
  price lower than the prevailing price for the
  items you consumed.
• Conversely, if price falls before maturity, then
  you must take delivery at maturity and you have
  bought at over the prevailing spot price.

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15Position Diagram for a Short

• We now graph the relation between spot price at
  maturity and profit for the short position in the
  ForEx example.

Profit from Position

1.05/
0
Spot Price at Maturity
-
Profit from Position
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16Larger Number of Positions

• Now suppose a firm holding a long position
  decides to double the size of that long position.
  The position diagram continues to intersect the
  horizontal axis at the same point, but the slope
  is twice as large. If the size of the long
  position is halved, then the slope is halved.

Profit from Position

0
Spot Price at Maturity
1.18/
-
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17Larger Number of Positions, Contd

• Denote the time t forward price for maturity at
  time T as FT,t. Let the size of the position
  taken be x, which can be either positive or
  negative. Let PT be the time T spot price.

Profit from Position

(PT - FT,t ) x, x 0
0
FT,t
Spot Price at Maturity, PT
-
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18Flexibility and Forwards

• Now lets review the nature of forward contracts
• They are OTC, and can be tailored to fit
  (ex-ante) the needs of the parties involved.
• But there are so many requirements about product
  type that have to be met, and
• parties are bound to dealing with the other party
  (i.e., a 1-to-1 relationship between shorts
  longs), and
• it is necessary to deliver unless the short gets
  the long to agree with some other form of
  settlement.
• Is there a way of locking into a future price
  without encountering these inconveniences? Yes
  futures contracts.

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19Comparison of Forwards with Futures

• a

Forwards
Futures
Ex-Ante Fit
?
?
Liquidity
?
?