Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 2. Equity and Currency Forwards

INTRODUCTION

A forward contract is an agreement made directly between two parties to buy and to sell a commodity or financial asset:

• on a specific date in the future;

• at a fixed price that is agreed at the outset between the two parties.

Forwards are bilateral over-the-counter (OTC) transactions, and at least one of the two parties concerned is normally a bank or some other financial institution. OTC transactions are used extensively by corporations, traders and investing institutions who are looking for a deal that is tailored to meet their specific requirements. Futures are similar in their economic effects but are standardized contracts traded on organized and regulated exchanges (see Chapters 4 and 5). Forwards involve counterparty risk – the risk that the other party to the deal may default on its contractual obligations.

Suppose that a trader agrees today to buy a share in one year's time at a fixed price of $100. This is a forward purchase of the share, also called a long forward position. The graph in Figure 2.1 shows the trader's potential profits and losses on the deal for a range of possible share values at the point of delivery. For example, if the share is worth $150 in one year's time, then the trader buys it through the forward contract and can sell it immediately, achieving a $50 profit. However, if the share is only worth $50 in one year's time, then the trader is still obliged to buy it for $100. The loss in that instance is $50. ...