Derivatives - Forward Contracts
A forward is an agreement between two counterparties - a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. Key features of forward contracts are:
- Highly customized - Counterparties can determine and define the terms and features to fit their specific needs, including when delivery will take place and the exact identity of the underlying asset.
- All parties are exposed to counterparty default risk - This is the risk that the other party may not make the required delivery or payment.
- Transactions take place in large, private and largely unregulated markets consisting of banks, investment banks, government and corporations.
- Underlying assets can be a stocks, bonds, foreign currencies, commodities or some combination thereof. The underlying asset could even be interest rates.
- They tend to be held to maturity and have little or no market liquidity.
- Any commitment between two parties to trade an asset in the future is a forward contract.
Example: Forward Contracts
Let's assume that you have just taken up sailing and like it so well that you expect you might buy your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to upgrade to a newer, larger model in 12 months. You and John could enter into a forward contract in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in 12 months for that price. In this scenario, as the buyer, you have entered a long forward contract. Conversely, John, the seller will have the short forward contract. At the end of one year, you find that the current market valuation of John's sailboat is $165,000. Because John is obliged to sell his boat to you for only $150,000, you will have effectively made a profit of $15,000. (You can buy the boat from John for $150,000 and immediately sell it for $165,000.) John, unfortunately, has lost $15,000 in potential proceeds from the transaction.
Like all forward contracts, in this example, no money exchanged hands when the contract was negotiated and the initial value of the contract was zero.