Introduction

A derivative is a contract between two

parties which derives its value/price from
an underlying asset. The most common
types of derivatives are futures, options,
forwards and swaps.
What is Forward
Contract?
A forward Contract is an agreement
between two counterparties - a buyer
and seller. The buyer agrees to buy an
underlying asset from the other party
(the seller). The delivery of the asset
occurs at a later time, but the price is
determined at the time of purchase.
 Features of Forwards

Highly customized - Counterparties can

determine and define the terms and
features to fit their specific needs,
including when delivery will take place
and the exact identity of the underlying
asset.
All parties are exposed to counterparty
default risk - This is the risk that the
other party may not make the required
delivery or payment.
Transactions take place in large, private
Underlying assets can be a stocks, bonds,
foreign currencies, commodities or some
combination thereof. The underlying asset
could even be interest rates.
They tend to be held to maturity and have
little or no market liquidity.
Any commitment between two parties to
trade an asset in the future is a forward
contract.
 Forward Spread Agreement

The counterparties of a forward spread

agreement contract into a spread between two
forward rate agreement rates applied to a
nominal amount of one currency. The
settlement amount will be the spread between
the reference rate minus the contracted spread.
 Exchange Rate Agreement
Aforeign exchangederivativebased
upon the difference between
twoforward exchange rates. This could
be the difference between
theprojectedcurrency
exchangerateswithin 3 month and 6
monthcontracts. Unlike
otherforwardexchangeagreements,
thespot ratedoes
notdirectlyfactorinto thevalue.
 Foreign Exchange Contract
A Forward Exchange Contract is a contract
between two parties whereby they commit
themselves to exchange a specified amount
of one currency for another at an agreed rate
of exchange, settlement of which takes place
on a fixed date in the future.

For Whom is this Facility made?

Importers and those with known
commitments such as dividends,
management fees, gratuities, interest and
principal repayments etc, who wish to fix the
kwacha value of USD, GBP, ZAR, EUR, etc.
What Are The Advantages?
1. Protection against currency exposure,
exchange rate movement, devaluation
etc
2. No cash flows except on maturity date
3. Costing is effective and determined in
advance
4. In a country like ours, where foreign
exchange availability follows seasonal
patterns, this becomes a practical
hedge.
Forward Rate Computation

.
Forward Contract Valuation
Example: BOB and ANDY (a real estate
related)
Andy has a property X cost = $1,00,000
Bob agreed to Buy X at a future date (one
year from today) @ $1,04,000 from Andy.
Andy and Bob entered into a Forward
Contract, so at the time of expiry/maturity
of the contract, the prevailing market price
would either profit buyer or seller
2
On execution date, the price of the
property was $1,10,000.
If we observe in case the property hiked
from $1,00,000 to $1,04,000, Andy earned
$4000 , but if current price rise up till
$1,10,000 and execution price is $1,04,000
therefore Andy has loss of $6000.
How Forward Price should be
agreed Upon
In a normal circumstance Andy can sell his
house today @$1,00,000.
Why he would go for Forward Contract?
To gain Profit.
What possible gain he could get and that
gain without any risk?
BANK gives INTEREST @ 4% = ?
$4000 would be earning profit on
$1,00,000
2
The minimum set FORWARD PRICE should
be= $1,04,000 so that even if Andy dont
get profit of $4000 from bank, he would
earn from Bob by selling @ same profit.
 The determination of FORWARD
PRICES
ASSET= INVESTMENT / CONSUMPTION
Investment: (stocks, shares, bonds)
Consumption: (copper, oil, food grains)
COMPOUNDING:
Normally,
But, if it COMPUNDED (M)A(1+R)n
Terminal value= times per annum then

Terminal value= A(1+ R/M)m n

A= amount of investment, R= rate of return, n= period of
return, m = period of compounding.
ASSUMPTIONS
There are no transaction costs
Same tax rate for all the trading profits
Borrowing and lending of money @ the
same risk free interest rate
Traders are ready to take advantage of
arbitrage opportunities as and when arise
These assumptions are equally available for
all the market participants; large or small.
Simple Forward Contract
When the underlying asset in the forward contract
does not pay any dividends, the forward price can
be calculated using the following formula:
F = S x e^(r x t)
Where:
F = the contract's forward price
S = the underlying asset's current spot price
e = the mathematical irrational constant
approximated by 2.7183
r = the risk-free rate that applies to the life of the
forward contract
t = the delivery date in years
2
For example, assume a security is currently
trading at $100 per unit. An investor wants
to enter into a forward contract that expires
in one year. The current annual risk-free
interest rate is 6%.
3
If the underlying asset pays dividends over the
life of the contract, the formula for the forward
price is:

F = (S - D) x e ^ (r x t)
Here, D equals the sum of each dividend's
present value, given as:
D = PV(d(1)) + PV(d(2)) + ... + PV(d(x)) = d(1) x
e ^ -(r x t(1)) + d(2) x e ^ -(r x t(2)) + ... + d(x)
x e ^ -(r x t(x))
assume that the security pays a 50-cent dividend
every three months.
Notations
T= Time remained up to delivery date in the
contract
S= Price of the underlying asset at present,
also called as spot or cash or current.
K= Delivery price in the contract at time T.
F= Forward or Future price today
f= value of a long forward contract today
r= Risk free rate of interest per annum today.
t= Current or today or present period of
entering the contract.
The Forward Price for INVESTMENT
ASSET (Securities)
Investment Assets providing no INCOME
Investment Assets providing a Known
INCOME
Investment Assets providing no INCOME

Easiest contract because such assets dont

give any income to the holder
Usually non-dividend paying equity shares
and discount bonds
Consider a long forward contract to purchase
a share (Non-dividend paying) in three
months. Assume that the current stock price
is Rs 100 and the three-month risk free rate
of interest is 6% per annum. Further assume
that the 3 months forward price is Rs 105. 2)
when it will be Rs 99.
Are you HOLDER or ARBITRAGEUR
Arbitrageur can adopt the following
strategy:

Borrow Buy

Go Pay off
Short Loan

Profit
Possible outcome
F= Se^rT
If F>Se^rT then the arbitrageur can BUY
the Asset and will go for SHORT forward
contract on the asset.
If F<Se^rT then he can short the asset and
go for long Forward contract on it
KNOWN INCOME
Usually stocks paying known dividends and
coupon-bearing bonds.
Consider a long forward contract to purchase a
coupon-bearing bond whose current price is
$900. we will suppose that the forward
contract matures in 9 months. We will also
suppose that the coupon payment of $40 is
expected after 4 months and 9-months risk-
free interest rates (continuously compounded)
are respectively, 3% and 4% per annum.
F0= (S0-I)S^rT
Forward Contract- Delivery
A delivery of the underlying asset at the date
agreed upon in a forward contract. At the
forward delivery, one party will supply the
underlying asset and one will buy the asset.
The terms and price of the asset was the one
agreed upon at the onset of the contract or
trade date.
2
The contract must include the security to
be sold
the price at which it is to be sold,
the date the payment is to be received and
include any other terms of the trade.
Forward contracts are normally used to
hedge the party from negative price
fluctuations in the underlying asset.
Forward Cancellation
Forward contract needs to be cancelled if a
customer so desires
This cancellation would involve taking an
opposite position with reference to current
position
This cancellation may be done either on
Due date
Early (before due date)
Steps for cancellation

Step 1: Identify original position

Step 2: Take opposite position

 Exporter

Cancellation Early
on due date cancellation

Original Original
position position:sell$for
:sell$forward ward
Opposite Opposite
position:buy$spo position:buy$fo
t rward
 Importer

Cancellation Early
on due date cancellation

Original Original
position position:buy$fo
:buy$forward rward
Opposite Opposite
position:sell$spo position:sell$for
t ward
 FUTURES
A future contract , just like a forward contract is an
agreement between the two parties to buy and sell
an asset, in future at a certain time and at a certain
price. Wherein a future contract is traded on an
organized or regulated exchange and are thus
bought and sold by the open outcry.
In other words, a future contract can also be
explained as a standardized agreement for
exchanging specific type of goods, in a specific
amount and at a specific future delivery or maturity
dates.
I
 EXAMPLES
If a farmer plans to grow 500 bushels of wheat next year,
then he can either grow the wheat and then sell it for
whatever the price of wheat is at that point of time, or he
can simply lock a price now by selling a future contracts that
will obligate him to sell the 500 bushels at a fixed price . By
doing so he can eliminate the risk of falling wheat prices.
An oil producer plans to produce 1 million barrels of oil ready
for delivery in exactly 365 days. Assuming that the price is
$50 per barrel. Thus if the oil producer enters into a future
contract priced at $53 per barrel, then the producer is
obligated to deliver 1 million barrels of oil and is guaranteed
to receive $53 million. And this $53 per barrel will be
received by the producer regardless of where the spot
market prices are at that time.
UNDERLYING ASSETS IN FUTURE
CONTRACT

UNDERLYING UNDERLYING
COMMODITIES FINANCIAL ASSETS
Wheat Foreign currency

Sugar Stock

Copper Bonds

Aluminum

Gold
 FEATURES
STANDARDIZATION
TRADED OVER EXCHANGE
LIQUIDITY
LOW COUNTER PARTY RISK
USED FOR HEDGING
EXPIRATION
Futures & Forwards Distinguished
FUTURES
They trade on exchanges
Are standardized
Identity of counterparties is
irrelevant
Regulated
Marked to market
Easy to terminate
Less costly
FORWARDS
Trade in OTC markets
Are customized
Identity is relevant
Not regulated
No marking to market
Difficult to terminate
More costly