Handbook of Market Risk by Szylar Christian;

Author:Szylar, Christian;
Language: eng
Format: epub
Publisher: Wiley
Published: 2013-10-15T00:00:00+00:00

8.1.2 The Forward Contract

A forward contract is a form of OTC that obliges one party to purchase a good from another party at a fixed future date for a price and currency specified in the terms of the contract. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. Forwards are frequently used to hedge positions against price fluctuations in the underlying security, or to speculate on the price movement of that security. Initiating a position in a forward does not require any financial outlay, so it allows for leveraged positions to be taken. Forward contracts are very similar to futures contracts, except they are not taken to market, exchanged, traded, or defined on standardized assets.

Example:

Microsoft goes to JP Morgan Chase and asks for a quote on a currency forward for €12 million in three months. JP Morgan Chase quotes a rate of $0.925, which would enable Microsoft to sell euros and buy dollars at a rate of $0.925 in three months' time. Under this contract, Microsoft would know it could convert its €12 million to $11,100,000 (12,000,000 × 0.925 = 11,100,000). The contract would also stipulate whether it will settle in cash or will call for Microsoft to actually deliver the euros to the dealer and be paid $11,100,000.

Now let us say that three months later, the spot rate for euros is $0.920. Microsoft is quite pleased that it locked in a rate of $0.925, as with the new spot rate they would receive: 12,000,000 × 0.920 = $11,040,000. Microsoft made a profit of $60,000 by entering into the forward currency contract.

However, had rates risen in the three-month period, Microsoft would have a made a loss (e.g., at a spot rate of $1.00, Microsoft would have received $12,000,000, but would still have to deliver the euros and accept a rate of $0.925, and therefore make a potential loss of $900,000).

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.