FORWARDS CONTRACTS

Unit Structure 3.0 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 Overview Learning Outcomes What is a Forward Contract? Examples/Scenarios Payoff Profiles Forward Options and Swaps Pricing of Forwards Summary Activities References & Readings

3.0

OVERVIEW

This unit focuses on the oldest derivative asset, namely a forward contract. It starts by defining such contract and discusses the other family on such contract namely forward options and forward swaps. Applications of such contracts are demonstrated together with its pricing.

3.1

LEARNING OUTCOMES

By the end of this unit, you should be able to do the following: 1. 2. 3.

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Define a standard forward contract and also other types of forwards commonly known as forward options and forward swaps. Analyse the use of such contracts in managing risks. Derive the pricing of forwards.

4.

Draw payoff profiles of long and short positions.

3.2

WHAT IS A FORWARD CONTRACT?

The forward contract is the simplest and oldest derivative asset. It is a contract/an agreement between two parties, a buyer and a seller to exchange a specified financial asset (or quantity of a commodity), at a specified future date, at a specified price. In a forward contract, one party assumes a long position, agreeing to buy the underlying asset. The other party assumes a short position, agreeing to sell the underlying asset. The date on which the exchange is to take place is called the delivery date and the price for which the asset will be exchanged is called the delivery price. An example of a forward contract is when a farmer, at planting time, agrees to deliver a specified quantity of grain at harvest time to a grain elevator, which in turn agrees to pay the farmer a specified price for the grain upon delivery. Forward contracts are common among firms of all sizes that have long-standing working relationships. However, the majority of forward trades in terms of value take place among large financial institutions and corporations. Forward contracts are said to be traded over-the-counter, that is, without the involvement of a third party or an organised exchange. Forward contracts are settled by delivery on the delivery date. The essential reason for the trading of forward contracts is that it allows both buyers and sellers to remove any uncertainty over the future price at which they must purchase/sell a given commodity. It should be noted that forward contract are available for both amount payable (example when requiring foreign currencies to import) and for amount receivables as well (example when exporting goods and services and expecting payment in foreign currencies). If a foreign currency stands at premium in the forward market, it shows that the currency is stronger than the home currency in that forward market. By contrast, if a foreign currency stands at a discount in the forward market, it shows that the currency is weaker than the home currency in that forward market. The words stronger and weaker are put in inverted commas

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because, in the context of forward markets, strength and weakness merely take account of interest rate differentials as suggested by interest rate parity.

3.3

EXAMPLES/SCENARIOS

Example 1 Consider a British bank which lends an American firm $3,000 with repayment of the loan to take place in one year and dollar interest charged at 10 per cent. The bank knows that, assuming the firm does not default, it will have a cashflow of $3,300 in one year. However, as a British institution, it would like to lock in the value of this cashflow in sterling. The risk of exchange rate movements implies that, without taking any other action, this would be impossible. The bank, therefore, enters into a one-year forward contract, in which it agrees to sell $3,300 at a rate of one pound sterling for $1.50. This fixes the banks cashflow from this project at 2.200. Note that at the time when the transaction actually occurs, in general one of the two parties will gain and one lose through the forward contract. The buyer loses if the price specified in the forward contract exceeds the price being charged in the spot market for the item in the question, while the seller loses if the converse is true. In terms of the example given above, the bank would be a loser if the spot exchange rate at the time the American firm repaid the loan was less than $1.50 per pound sterling. Example 2 Suppose that it is August 16 2007 and, firm A, a company based in the US knows that it will pay 10m on December 16, 2007 for goods it has purchased from a British firm. Firm A can buy pounds from a bank in a four-month forward contract and thus hedge against foreign exchange risk. Suppose the agreement is to buy 1 for $1.55 (US dollars). The firm has therefore hedged against exchange rate volatility. The amount to be paid in US dollars at on December 16, 2006 is 10mX1.55 = $15.5m.

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Suppose that on 16 November 2007 the exchange rate is 1=$3. This means that firm would have to pay 10mX3=$30m if it did not hedge again the exchange rate risk. Example 3 A European manufacturer sells solar modules to a New York utility company for US$15 million. The sale is agreed in January 2008 with delivery and payment scheduled for November 2008. In January, 1 equals US$1.50, so the contract is worth 10 million. The manufacturer pays his material and labour costs in euros, so it is important that he protects himself against a fall in the US dollar relative to the euro. Therefore, he enters into a derivative contract on the US dollar with his bank as the counterparty. The contract gives him the obligation to sell US$15 million at an exchange rate of US$1.50 per euro to his bank in November 2008. If the US dollar falls to US$2 per euro by November 2008, the US$15 million will only be worth 7.5 million to the manufacturer. The derivatives contract protects against this potential loss: the manufacturer receives 10 million from the bank in November 2008, as originally agreed, for the US$15 million, despite the dollars severe depreciation. Example 4 Consider a Mexican exporter who expects to receive 100 million in six months. Suppose that the price of the euro is $1.20 now. If the price of the euro falls by 10 percent over the next six months, the exporter loses $12 million. By selling euros forward, the exporter locks in the current forward rate (if the forward rate is $1.18, the exporter receives $118 million at maturity). Financial hedging involves taking a financial position to reduce ones exposure or sensitivity to a risk; hedging is perfect when all exposure to the risk is eliminated through the financial position. In our example, the financial position is a forward contract, the risk is the euro, the exposure is 100 million in six months, and the exposure to the euro is perfectly hedged with the forward contract. Since no money changes hands when the exporter buys euros forward, the market value of the forward contract must be zero when initiated since otherwise the exporter would get something for nothing.

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3.4

PAYOFF PROFILES

The payoff from a forward contract at delivery will depend on the spot price of the asset on the delivery date, that is, the price at which the asset can be purchased or sold for immediate delivery on that date. The payoffs from long and short forward positions at delivery, as functions of the spot price on the delivery date ST and the delivery price K, are illustrated in Figure below. In general, the payoff at delivery from a long forward position is ST - K: if ST > K, the long investor gains because he is entitled to purchase an asset that is worth ST at a lower price K; If ST < K, the long investor loses because he is obligated to purchase an asset that is worth ST at a higher price K. The payoff at delivery from a short forward position is the exact opposite of that from a long position. In general, the payoff from a short forward position is K - ST .

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3.5

FORWARD OPTIONS AND SWAP DEALS

Forward options and swaps are best explained through an illustrative example. Consider the following example Adapted from Buckley (2004) Chapter 13, page 214 Contract data Seller Buyer Contract date Credit term Expected payment date Invoice value UK exporter French importer 1 May 2005 3 months 31 July 2005 EURO 5m

Exchange rates quotes at 1 May 2005 Spot 1 month forward 2 months forward 3 months forward 4 months forward 7.92 - 7.93 3 7/8 3 cpm 6 - 6 1/8 cpm 9 5/8 8 7/8 cpm 12 - 11 5/8 cpm

Outright exchange rates quotes at 1 may 1995 Spot 1 month forward 2 months forward 3 months forward 4 months forward 7.92 - 7.93 7.88 7/8 7.90 7.86 7.87 3/8 7.83 1/8 7.84 5/8 7.80 7/8 7.81 1/8

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Mechanism of forward contract 1 May 2005 31 July 2005 UK exporter sells EURO 5m forward 3 months at 7.84 5/8 UK exporter receives EURO 5m from French importer UK exporter delivers EURO 5m and receives sterling at the rate of EURO 7.84 5/8 equals 1 For EURO 5m he receives 637,755 Indeed in the reality of business world, a trader cannot be certain when one will pay a bill as the counter party may do so before the due date or may pay afterwards. In the example of the above figure, it is assumed that the French customer would pay on 31 July 2005, that is, three months after invoice date. However, it may also happen that the French purchaser decides to pay on some uncertain date between 30 June and 31 August 2005. Forward Options Indeed the British exporter may decide to cover despite an uncertain payment date via a forward option (probably because the delivery date may be uncertain as well). Indeed like all forward contracts, the exchange rate is irrevocably fixed when the contract is made. However in a forward option contract, the precise maturity date is left open and it is for the firm to decide subsequently. Coming to our numerical example, assume that the UK exporter expects payment between 30 June and 31 August 2005- that is between two and four months from invoice date. The bank charges its customer the worst rate during the option period. Thus from the previous scenario, the forward option is over the third and fourth months. The rate to the seller of EURO is the full two months discount. This is the worst rate between month 2 and month 4 for selling EUROS.

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It should be clearly understood that the forward option contract is not a currency option (discussed later on). The forward option is optional in terms of the date of delivery currency must be delivered under the contract. Swap Deals Another method of dealing with unspecified settlement is a swap deal. This method is most of the time cheaper than covering by way of forward options. A swap involves the simultaneous buying and selling of a currency for different maturities. Swap deals used for forward cover are of two types: forward/forward and spot/forward. In either case, the exporter begins by covering the foreign currency transaction forward to an arbitrarily selected but fixed date, just as in an ordinary fixed-date forward contract. Then if the precise settlement date is subsequently agreed before the initial forward contract matures, the original settlement date may be extended to the exact date by a forward/forward swap. In fact if an exact settlement date is not agreed by the date when the initial forward contract matures, the forward cover may be extended by a spot/forward swap. A forward/forward swap, or forward swap, is merely a pair of forward exchange contracts involving a forward purchase and a forward sale of a currency, simultaneously entered into but for different maturities, Bukley (2004) Assume that the details of an export contract from Britain to France as per contract above, however let us assume that the expected settlement date is uncertain, probably because the delivery date is equally uncertain. The British exporter takes out a forward contract on 1 May 2005 (the date of the sale contract). This forward contract is for an arbitrary period of 2 months. Therefore, he or she sells EURO 5m forward for delivery on 30 June 2005. Now let us suppose that on 20 June 2005, the UK exporter and French purchaser agree that settlement will take place on 31 July 2005. The British exporter thus needs to counter the original forward sale of EUROS for settlement on 30 June and replace it with a contract for delivery on 31 July. He or she does buy EURO 5m forward for delivery on 30 June (contract of the original forward sale of EURO)

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and simultaneously selling EURO 5 cm forward 41 days, thereby extending delivery to 31 July. Let us further assume that on 20 June 2005, the bank gives the UK exporter the following quotes Spot 10 days forward 1 month forward 41 days forward 7.94-7.95 7.9425-7.9550 7.9450-7.9575 7.9475-7.9600

Here below is a summary of transactions and the net payment/receive: 1 May 2005 Sell EURO 5m for forward 2 months At 7.87 (delivery 30 June 2005) 20 June 2005 Buy EURO 5m for forward 10 days At 7.9425(delivery 30 June 2005) 20 June 2005 Sell EURO 5m for forward 41 days At 7.96 (delivery 31 July 2005) Net sterling proceeds 633.637 628.141 (629,525) 635,021

As can be seen from the above, in the second transaction, the overall mechanism reverses the first one. The second and third transactions are the opposite sides of the forward swap. The effect of the above forward swap is that the British exporter has locked in as of 1 May 2005 at the forward rate for two months cover adjusted for the premium/discount for a further month given by the bid/offer spread offer incurred on the forward/forward swap. A spot/forward swap is similar to a forward swap. It again involves a simultaneous pair of foreign exchange contracts, one of which is a spot contract while the other is a forward contract.

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Activity 1 Attempt a spot/forward swap from the above example. Refer to Buckley, 2004 for treatment of similar problem.

In practice, the forward/forward or spot/forward swap is the preferred method of dealing with a continuing stream of foreign currency payments or receipts. Where a firms sales include a large number of small transactions denominated in foreign currency terms, it is expensive both in transaction and administrative costs to cover each individual deal. This problem may be overcome by taking out a single, large forward option contract to cover the approximate expected total cash value of the large number of different receivables or payables. Although the large number of small exports would normally have different settlement dates, forward options are ideally suited to this kind of situation.

3.6

PRICING OF FORWARDS

The section above provided an introduction to the most common (but by no means the only) derivative assets which are traded. In this section, we shall see how an institution (usually a merchant bank) prices these assets. The underlying principle which will be employed in pricing is absence of arbitrage. Before getting into pricing issues however, we present a short note on continuous compounding.

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Continuous Compounding Recall from your basic finance courses. Assume an amount X is invested for a single year at rate r per annum. If compounding occurs once a year, the terminal value of the investment is X (1+r). Similarly, if the compounding occurs k times per year (still at annual rate r) the terminal value is: r X (1 + ) k k This is known as discrete compounding, that is since k is a known figure, no matter how large it may be, the terminal value will be computed. Continuous compounding involves allowing the number of compounding dates within a year to tend to infinity and under this assumption the expression tends to Xern. Pricing Currency forwards The price of a currency forward is: F = S e(r-rf)(T-t) f S r rf t = forward rate = = = = spot rate rate of interest in the domestic economy rate o interst in foreign economy time

Assume r is the domestic rate and r f is the foreign interest rate. The pricing of currency forwards is based on the covered interest parity and is derived as follows. Consider an investor who currently has $1. They have two alternative investment strategies; investment in the domestic risk-free asset and investment in the foreign, for example France, risk-free asset. Investment of
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the dollar at the domestic rate yields a terminal value of e

r (T- t).

To invest at the foreign rate, the

investor must first exchange his dollar for yen at the spot exchange (S). The exchange rate is quoted as the domestic price of a unit of foreign currency, hence the $1 translates to EURO S-1. This is then invested at the foreign rate yielding a terminal value of: 1 erf(T-t) S Finally, to lock in the dollar receipts from the foreign investment, the investor sells the known proceeds forward at forward rate F. Thus, the dollar receipts from the foreign investments are: F erf(T-t) S Note that every interest rate and exchange rate used in both the above calculations are known at the present rate, t. In equilibrium, it must be the case that the dollar proceeds from a riskfree US investment equal those from a risk free French investment, hence the forward must be set such that: F erf(T-t) =er(T-t) S Which implies that, as given above, the equilibrium forward exchange rate is: F=Se(r-rf)(T-t) The formula tells us that the forward exchange rate differs from the spot exchange rate by a factor which is determined by the interest rate differential between the respective countries.
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Currency forwards (and futures) are widely employed as instruments to remove foreign exchange risk. As in the derivation of the forward price, investors can use these contracts to tie down the domestic currency value of a foreign currency cash-flow to be received at a future date. Pricing forward contracts (other than foreign currency) In fact, the forward price implied by absence of arbitrage argument is as follows: F = Se r (T- t) (I.e. the forward price is the current spot price (S) continuously compounded over the life of the forward contract).

3.7

SUMMARY
The forward contract is the simplest and oldest derivative asset. It is a contract/an agreement between two parties, a buyer and a seller to exchange a specified financial asset (or quantity of a commodity), at a specified future date, at a specified price.

The essential reason for the trading of forward contracts is that it allows both buyers and sellers to remove any uncertainty over the future price at which they must purchase/sell a given commodity.

The payoff from a forward contract at delivery will depend on the spot price of the asset on the delivery date, that is, the price at which the asset can be purchased or sold for immediate delivery on that date.

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In a forward option contract, the precise maturity date is left open and it is for the firm to decide subsequently.

Another method of dealing with unspecified settlement is a swap deal. This method is most of the time cheaper than covering by way of forward options. A swap involves the simultaneous buying and selling of a currency for different maturities. Swap deals used for forward cover are of two types: forward/forward and spot/forward.

Forward exchange rate differs from the spot exchange rate by a factor which is determined by the interest rate differential between the respective countries.

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