Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 3

Introduction to Forward Contracts

The forward contract is the most basic derivative contract. A forward contract is an agreement to buy or sell something in the future. The agreement is made today to exchange cash for a good or service at a later date. This differs from a spot transaction, which is the usual way of buying or selling something. In a spot transaction, one party pays for a good or service, and immediately receives that good or service.

This chapter first describes the general concepts of forward contracts. Then, greater details are presented concerning two types of forward contract that are prevalent in modern business operations and are used to manage financial price risk: the forward rate agreement (FRA), which is an arrangement to borrow or lend money at a future date at an agreed upon interest rate, and the forward foreign exchange contract, in which a party agrees to buy or sell an amount of a foreign currency at a future date.


3.1 GENERAL CONCEPTS

When a forward contract is created, there must always be two parties: the buyer and the seller. The buyer of a forward contract agrees to buy something in the future. The buyer is also said to have a long position, or be long the forward contract. The seller of a forward contract has the obligation to sell something in the future, and is said to have a short position.

The terms of the contract are agreed upon today, and delivery and payment take place in the future, at what is called either the delivery date, the settlement date, or the maturity date of the contract. The buyer has agreed to take delivery and the seller has agreed to make delivery.

Money rarely changes hands when a forward contract is originated (unless one or both of the parties demands “good faith” money to serve as collateral that backs up the obligations stated in the contract). Payment from the buyer of the forward contract to the seller is generally made only upon the delivery of the good.

Most business transactions are actually forward transactions. A firm might order 10,000 widgets from another firm. The price is agreed upon today. No cash flows occur today. The widgets will be delivered one month hence. Payment is not made until after the widgets have been received. For all practical purposes, this is a forward contract.

The failure of a party to do what has been agreed to, as stated in the contract, is known as default. On the day that a forward contract is originated, both parties face potential default risk, the most extreme form of credit risk, which describes the future uncertainty concerning the other party's ability and/or willingness to fulfill the terms of the contract.1 For most everyday forward transactions we enter into, there are no penalties for defaulting. If you fail to show up at

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