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

2

Equity and Currency Forwards

INTRODUCTION

In a physically delivered forward contract one party agrees to buy and the other to sell a commodity such as oil or a financial asset such as a share:

• on a specific date in the future;

• at a fixed price that is agreed at the outset.

Some contracts are cash-settled. This means that one party pays the other the difference between the fixed price stated in the contract and the actual market value of the underlying commodity or asset on a future date.

Forwards are bilateral over-the-counter (OTC) transactions, and at least one of the parties involved is normally a financial institution. OTC deals are used by corporations, traders and investing institutions. They can be tailored to meet 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 potentially involve counterparty risk - the risk that the other party may default on its contractual obligations.

Note that throughout this book the term share is used to mean an equity security such as an IBM share. In the US the expression ‘common stock’ is also used. Shares represent a stake in a business, normally carry voting rights, and are paid dividends out of the company’s net profits after it has made due payments on its debt.

EQUITY FORWARD CONTRACT

Suppose that a trader agrees today to buy a share in a year’s time at a fixed price of $100. This is a forward purchase, ...