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.

Example 1:
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.

Example 2:
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.
 

Look Out!
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.

Forward Contracts on Bonds
Related Articles
  1. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  2. Personal Finance

    Invest in Costco? First Understand Its Balance Sheet

    A strong balance sheet sets a company apart and boosts investor confidence. How healthy is Costco based on an analysis of its balance sheets from the last two years?
  3. Investing Basics

    Brokers and RIAs: One and the Same?

    Brokers and registered investment advisors have some key differences. Here's what you need to know.
  4. Professionals

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  5. Professionals

    How To Make Money Using Tobin's Q Ratio

    Although it seems simple, Tobin's Q Ratio is more complex than it appears. We explore some of its main strengths and weaknesses.
  6. Taxes

    3 Secrets You Didn't Know About Estate Planning

    Every advisor and saver needs to know these three estate planning secrets.
  7. Professionals

    Cash Flow Is King: How to Keep it Running

    Why is cash flow so important, and what steps can a business take to improve it?
  8. Entrepreneurship

    10 Ways to Nurse Cash Flow in Healthcare

    Running a business in healthcare? You might want to rethink cash flow management practices.
  9. Professionals

    How to Help Clients with Cash Flow Issues

    Sometimes your spending gets out of hand or income has a hiccup. Here's how financial advisors can help clients who have cash flow issues.
  10. Professionals

    How to Improve Your Cash Flow in Manufacturing

    Here are 10 ways to to improve a manufacturer's cash flow.
RELATED TERMS
  1. Personal Financial Advisor

    Professionals who help individuals manage their finances by providing ...
  2. CFA Institute

    Formerly known as the Association for Investment Management and ...
  3. Chartered Financial Analyst - CFA

    A professional designation given by the CFA Institute (formerly ...
  4. Security Analyst

    A financial professional who studies various industries and companies, ...
RELATED FAQS
  1. What are the differences between a Chartered Financial Analyst (CFA) and a Certified ...

    The differences between a Chartered Financial Analyst (CFA) and a Certified Financial Planner (CFP) are many, but comes down ... Read Full Answer >>
  2. How do I become a Chartered Financial Analyst (CFA)?

    According to the CFA Institute, a person who holds a CFA charter is not a chartered financial analyst. The CFA Institute ... Read Full Answer >>
  3. What types of positions might a Chartered Financial Analyst (CFA) hold?

    The types of positions that a Chartered Financial Analyst (CFA) is likely to hold include any position that deals with large ... Read Full Answer >>
  4. Who benefits the most from prepaid expenses?

    Prepaid expenses benefit both businesses and individuals. Prepaid expenses are the types of expenses that are bought or paid ... Read Full Answer >>
  5. If I am looking to get an Investment Banking job. What education do employers prefer? ...

    If you are looking specifically for an investment banking position, an MBA may be marginally preferable over the CFA. The ... Read Full Answer >>
  6. Can I still pass the CFA Level I if I do poorly in the ethics section?

    You may still pass the Chartered Financial Analysis (CFA) Level I even if you fare poorly in the ethics section, but don't ... Read Full Answer >>
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!