Why Forward Contracts Are The Foundation Of All Derivatives

By Troy Adkins AAA

The most complex type of investment products fall under the broad category of derivative securities. For most investors, the derivative instrument concept is hard to understand. However, since derivatives are typically used by governmental agencies, banking institutions, asset management firms and other types of corporations to manage their investment risks, it is important for investors to have a general knowledge of what these products represent and how they are used by investment professionals.

Forward Derivative Contract Overview

As one type of derivative product, forward contracts can be used as an example to provide a general understanding of more complex derivative instruments such as futures contracts, options contracts and swaps contracts. Forward contracts are very popular because they are unregulated by the government, they provide privacy to both the buyer and seller, and they can be customized to meet both the buyer's and seller's specific needs. Unfortunately, due to the opaque features of forward contracts, the size of the forward market is basically unknown. This, in turn, makes forward markets the least understood of the various types of derivative markets.

Due to the overwhelming lack of transparency that is associated with the use of forward contracts, many potential issues may arise. For example, parties that utilize forward contracts are subject to default risk, their trade completion may be problematic due to the lack of a formalized clearinghouse, and they are exposed to potentially large losses if the derivatives contract is structured improperly. As a result, there is the potential for severe financial problems in the forward markets to overflow from the parties that engage in these types of transactions to society as a whole. To date, severe problems such as systemic default among the parties that engage in forward contracts have not come to fruition. Nevertheless, the economic concept of “too big to fail” will always be a concern, so long as forward contracts are allowed to be undertaken by large organizations. This problem becomes an even greater concern when both the options and swaps markets are taken into account.

Trading and Settlement Procedures for a Forward Derivative Contract

Forward contracts trade in the over-the-counter market. They do not trade on an exchange such as the NYSE, NYMEX, CME or CBOE. When a forward contract expires, the transaction is settled in one of two ways. The first way is through a process known as “delivery.” Under this type of settlement, the party that is long the forward contract position will pay the party that is short the position when the asset is delivered and the transaction is finalized. While the transactional concept of “delivery” is simple to understand, the implementation of delivering the underlying asset may be very difficult for the party holding the short position. As a result, a forward contract can also be completed through a process known as “cash settlement.”

A cash settlement is more complex than a delivery settlement, but it is still relatively straightforward to understand. For example, suppose that at the beginning of the year a cereal company agrees through a forward contract to buy 1 million bushels of corn at $5 per bushel from a farmer on Nov. 30 of the same year. At the end of November, suppose that corn is selling for $4 per bushel on the open market. In this example, the cereal company, which is long the forward contract position, is due to receive from the farmer an asset that is now worth $4 per bushel. However, since it was agreed at the beginning of the year that the cereal company would pay $5 per bushel, the cereal company could simply request that the farmer sell the corn in the open market at $4 per bushel, and the cereal company would make a cash payment of $1 per bushel to the farmer. Under this proposal, the farmer would still receive $5 per bushel of corn. In terms of the other side of the transaction, the cereal company would then simply purchase the necessary bushels of corn in the open market at $4 per bushel. The net effect of this process would be a $1 payment per bushel of corn from the cereal company to the farmer. In this case, a cash settlement was used for the sole purpose of simplifying the delivery process.

Currency Forward Derivative Contract Overview

Derivative contracts can be tailored in a manner that makes them complex financial instruments. A currency forward contract can be used to help illustrate this point. Before a currency forward contract transaction can be explained, it is first important to understand how currencies are quoted to the public, versus how they are used by institutional investors to conduct financial analysis.

If a tourist visits Times Square in New York City, he will likely find a currency exchange that posts exchange rates of foreign currency per U.S. dollar. This type of convention is used frequently. It is known as an indirect quote and is probably the manner in which most retail investors think in terms of exchanging money. However, when conducting financial analysis, institutional investors use the direct quotation method, which specifies the number of units of domestic currency per unit of foreign currency. This process was established by analysts in the securities industry, because institutional investors tend to think in terms of the amount of domestic currency required to buy one unit of a given stock, rather than how many shares of stock can be bought with one unit of the domestic currency. Given this convention standard, the direct quote will be utilized to explain how a forward contract can be used to implement a covered interest arbitrage strategy.

Assume that a U.S. currency trader works for a company that routinely sells products in Europe for euros, and that those euros ultimately need to be converted back to U.S. dollars. A trader in this type of position would likely know the spot rate and forward rate between the U.S. dollar and the euro in the open market, as well as the risk-free rate of return for both the U.S. dollar and the euro. For example, the currency trader knows that the U.S. dollar spot rate per euro in the open market is $1.35 U.S. dollars per euro, the annualized U.S. risk-free rate is 1% and the European annual risk-free rate is 4%. The one-year currency forward contract in the open market is quoted at a rate of $1.50 U.S. dollars per euro. With this information, it is possible for the currency trader to determine if a covered interest arbitrage opportunity is available, and how to establish a position that will earn a risk-free profit for the company by using a forward contract transaction.

Example of a Covered Interest Arbitrage Strategy

To initiate a covered interest arbitrage strategy, the currency trader would first need to determine what the forward contract between the U.S. dollar and euro should be in an efficient interest rate environment. To make this determination, the trader would divide the U.S. dollar spot rate per euro by one plus the European annual risk-free rate, and then multiply that result by one plus the annual U.S. risk-free rate.

[1.35 / (1 + 0.04)] x (1 + 0.01) = 1.311

In this case, the one-year forward contract between the U.S. dollar and the euro should be selling for $1.311 U.S. dollars per euro. Since the one-year forward contract in the open market is selling at $1.50 U.S. dollars per euro, the currency trader would know that the forward contract in the open market is overpriced. Accordingly, an astute currency trader would know that anything that is overpriced should be sold to make a profit, and therefore the currency trader would sell the forward contract and buy the euro currency in the spot market to earn a risk-free rate of return on the investment.

The covered interest arbitrage strategy can be achieved in four simple steps:

Step 1: The currency trader would need to take $1.298 dollars and use it to buy €0.962 euros.

To determine the amount of U.S. dollars and euros needed to implement the covered interest arbitrage strategy, the currency trader would divide the spot contract price of $1.35 U.S. dollars per euro by one plus the European annual risk-free rate of 4%.

1.35 / (1 + 0.04) = 1.298

In this case, $1.298 U.S. dollars would be needed to facilitate the transaction. Next, the currency trader would determine how many euros are needed to facilitate this transaction, which is simply determined by dividing one by one plus the European annual risk-free rate of 4%.

1 / (1 + 0.04) = 0.962

The amount that is needed is €0.962 euros.

Step 2: The trader would need to sell a forward contract to deliver €1.0 euro at the end of the year for a price of $1.50 U.S. dollars.

Step 3: The trader would need to hold the euro position for the year, earning interest at the European risk-free rate of 4%. This euro position would increase in value from €0.962 euro to €1.00 euro.

0.962 x (1 + 0.04) = 1.000

Step 4: Finally, on the forward contract expiration date, the trader would deliver the €1.00 euro and receive $1.50 U.S. dollars. This transaction would equate to a risk-free rate of return of 15.6%, which can be determined by dividing $1.50 U.S. dollars by $1.298 U.S. dollars and then subtracting one from the answer to determine the rate of return in the proper units.

(1.50 / 1.298) – 1 = 0.156

The mechanics of this covered interest arbitrage strategy are very important for investors to understand, because they illustrate why interest rate parity must hold true at all times to keep investors from making unlimited risk-free profits.

The Link Between Forward Contracts and Other Derivatives

As this article illustrates, forward contracts can be tailored as very complex financial instruments. The breadth and depth of these types of contracts expands exponentially when one takes into account the different types of underlying financial instruments that can be used to implement a forward contract strategy. Examples include the use of equity forward contracts on individual stock securities or index portfolios, fixed income forward contracts on securities such as treasury bills, and interest rate forward contracts on rates such as LIBOR, which are more commonly known in the industry as forward-rate agreements.

Finally, investors should understand that forward contract derivatives are typically considered the foundation of futures contracts, options contracts and swap contracts. This is because futures contracts are basically standardized forward contracts that have a formalized exchange and clearinghouse. Options contracts are basically forward contracts that provide an investor an option, but not an obligation, to complete a transaction at some point in time. Swaps contracts are basically a linked-chain agreement of forward contracts that require action to be taken by investors periodically over time.

The Bottom Line

Once the link between forward contracts and other derivatives is understood, investors can quickly start to realize the financial tools that are at their disposal, the implications that derivatives have for risk management, and how potentially large and important the derivatives market is to a host of governmental agencies, banking institutions and corporations throughout the world.

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