Forward Contracts

Question 1

What is a forward contract?

Answer 1

A forward contract is a non-standardised, privately negotiated over-the-counter (OTC) agreement between two counterparties to buy or sell an asset at a specified date in the future for a certain specified price (forward price).

Question 2

What are the key differences between a forward contract and a future contract?

Answer 2

1) Trading venue
- Forward contracts are traded OTC, meaning they are private agreements between two parties.
- Futures contracts are traded on organised exchanges (e.g., CME).

2) Standardisation
- Forwards are customisable as the terms (quantity, quality, delivery date etc.) are negotiated between counterparties.
- Futures are standardised as the exchange sets contract specifications.

3) Counterparty risk
- Forwards carry higher default risk if traded bilaterally (as there is no intermediary guaranteeing performance). However, this can be overcome using a central counterparty.
- Futures have lower default risk because the exchange clearing house acts as an intermediary and requires margin deposits.

4) Settlement
- Forward contracts are usually settled at maturity, often by physical delivery or cash.
- Futures contracts are marked-to-market daily, with profits/losses settled daily until the contract is closed.

Question 3

Why does only one party have the motivation to default on a forward contract?

Answer 3

Only one party has the motivation to default because the value of a forward contract changes over time due to market price fluctuations. As the contract’s value shifts from its initial valueless state, one party’s position becomes an asset (positive value), while the other’s becomes a liability (negative value). The party holding the liability would face a financial loss if they fulfil the contract, thus having an incentive to default. Conversely, the party in a profitable position has no motivation to default, as they stand to gain from contract execution.

Question 4

What is the value of the default risk in a forward contract?

Answer 4

The value of the winning position in the forward contract.

Question 5

What are the advantages of a long hedge using forwards?

Answer 5

• Purchase price is locked in (benefit if spot price increases)
• No initial cash outlay
• Transaction costs may be lower in forwards than in spot trading
• It is easier to offset a long forward position than to find a buyer for a commodity already bought

Question 6

What are the disadvantages of a long hedge using forwards?

Answer 6

• The spot price may fall
• Default risk is present
• Two sets of transactions may be incurred: trading forward and trading at spot if the forward contract is not settled by delivery
• Imperfect hedge due to transaction costs

Question 7

What is the difference between a long forward position and a short forward position?

Answer 7

When a trader enters into a long forward contract, they are agreeing to buy the underlying asset for a certain price at a certain time in the future. When a trader enters into a short forward contract, they are agreeing to sell the underlying asset for a certain price at a certain time in the future.

Question 8

Explain what happens when an investor shorts a certain share?

Answer 8

They borrow the share from another party and sell it immediately in the market, expecting the price to fall. Later, the investor buys back the share at a lower price, returns it to the lender, and profits from the difference. However, if the share price rises, the investor incurs a loss. An investor with a short position must pay any income earned, such as dividends or interest/coupon, to the lender.