CFA Level 1
Derivatives - Equity Forward Contracts
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.
Assume that a client owns IBN at 100 and wants to sell IBN stock in six months to raise some cash. The client can enter into an equity forward in which he will receive a price of $125.
- If the price remains at or below $125, the client will receive $125 per share in six months.
- If the stock price is at $130, the client will still have to delivery 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.
As an example, if the dealer quotes $15,000 for six securities in your portfolio and you decide to enter into the contract, you will receive that amount at the expiration of the contract.
Forward contracts on stock indexes afford portfolio managers a way to protect the value of their portfolios or to try to reduce and/or eliminate risk in a portfolio that mimics a major index. Instead of having a contract for the individual securities, the manager could enter into a forward contract to sell the index at a future date.
Let's say that you want to protect your portfolio of S&P 500 securities. You contact a dealer who gives you a quote of $5,000 on a forward contract for $170,000,000 to sell the index. These contracts are typically settled in cash payments instead of actual delivery. If the index were to drop by 2%, your portfolio would lose $3,400,000 (170,000,000 x .02). Because you entered into a forward contact with the dealer to sell the index, you benefit from the market decline of 2% to the tune of $340,000 (170,000,000 x .02). Or, to view it another way, you can purchase the index at the future date of the contract at $16,660,000 and sell it to the dealer at $170,000,000. As you can see, the gain from the forward contract zeros out the loss on the portfolio from the market decline and protects the portfolio.
Dividends do have an effect on forwards; however, when you compare the effect in a risk management perspective for a portfolio or index, dividends have a minor impact when compared to the price movements in the equities that underlie the index or portfolio.
Most forwards do not pay dividends except for forwards that are "total return" forwards. Total return forwards take into consideration the payments and reinvestment of dividends within the index in addition to the return on the index and the payoff of any forward contract based on it.
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