Forward Contracts

Forward Contracts

A forward contract is an agreement between two parties to buy or sell (obligation) a commodity or asset (underlying asset, underlying instrument) at a specific future date for an agreed upon price. Typically, the contract is between a producer and a merchant; a dealer and an end user; two financial institutions; or a financial institution and a client.

The difference between a forward contract and a futures contract is that a futures contract is a standardized contract, traded on a futures exchange and cleared by third party clearinghouse. In addition, as the forward contract is not exchange traded there is no margin requirement as is usual on a futures exchange. As the forward contract is not exchange traded it is also more flexible than a futures contract: the two parties may define their own delivery date, underlying contract quantity, etc. Thus, forward contracts can be considered a private, customized futures contract with non-standard terms.

The Forward Market is the over the counter market for future delivery or, in the case of physical commodities, for later shipment. In the United States it can also mean trading outside a commodities exchange for delivery at a future date.

The party that has agreed to buy (receive) the underlying asset has entered into a long forward contract.

The party that has agreed to sell (deliver) the underlying asset has entered into a short forward contract.

The advantage of the contract to perhaps a commodity producer is that they have locked in a known price to sell the commodity when it is delivered on the forward contract delivery date. However, they lose the benefit of an increase in the spot price if the spot price is higher than the forward contract price on the date of delivery (lost opportunity). Conversely, the merchant or processor has locked in the price of the supply of the commodity on the delivery date. However, again, they lose the benefit of a decline in the spot price if the spot price is lower than the forward contract price on the date of delivery.

A Forward contract is considered a derivative product as the contract has no intrinsic value other than that which can be derived from the cash value or income stream value of an underlying asset.

There is no initial payment to enter into a forward contract and no payment is made during the term of the contract. A forward contract can be cash settled or settled by actual delivery of the underlying asset.

The basic forward price is determined by:

F(S, t)

t = time to expiration

S = spot price of the underlying asset

The equation must then also take into consideration the time value of money (during the outstanding period of the contract). When a commodity is involved then the forward price is further determined by the inclusion of the cost to carry (cost of funds + storage cost)

How to cash settle a forward contract? The cash settlement is equal to the notional amount (N) multiplied by the delivery date spot price (S) minus the contract / delivery price (k) or N(S - k). The cash settlement price fluctuates in response to market conditions up to the date of delivery.

Cash Settlement Example:

1,000 barrrels crude oil (N)

$51.21 spot price (S)

$50.04 contract price (k)

1,000 (51.21 - 50.04) = $1,170. The contract could be settled by a cash payment of $1,170 by the seller (short) to the purchaser (long). If the delivery date spot price is less than the contract price (negative result) then the long forward would pay the short forward (because why take delivery at the contract price if the asset could be purchased for less in the spot market on the delivery date).

Credit Issues

Forward contracts are not Exchange traded and each party is responsible for the credit worthiness of the counterparty.

There is no margin requirement or daily settlement / mark-to-market. However, the parties can negotiate a margin requirement into the contract if both parties agree.

Types of Forward Contracts

Forward Rate Agreements (FRAs)

An over the counter, cash settled forward contract on interest rates, usually LIBOR (sort of the OTC equivalent of a Eurodollar futures contract).

Confirmed agreement between two parties to exchange an interest rate differential on a notional principal amount at a given future date.

A contract that fixes the interest now that will apply to a loan or deposit for a particular amount for a given period starting on a certain date in the future (the settlement date).

FRA maturities usually correspond to Eurodollar time deposit maturities.

The Seller of an FRA agrees to pay the Buyer the increased interest expense if the contract referenced LIBOR maturity interest rate is higher than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount.

The Buyer of an FRA agrees to pay the Seller the decreased interest expense if the contract referenced LIBOR maturity interest rate is lower than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount.

On the settlement date no actual principal is exchanged. Rather, the buyer and the seller calculate the present value of the net interest owed, and one party makes a cash settlement payment.

The formula for determining the payment is:

(N = Notional Principal Amount)   (LIBOR = LIBOR value on Settlement Date for the maturity specified by the contract)   (FR = Forward Rate specified by the contract)   (dtm = Days to Maturity of the Forward Rate)

Example:

Notional Amount of Principal: USD10,000,000

Settlement in One Month

Forward Rate of 4% (four percent) on a Eurodollar Deposit, 90-days (three months)

Actual 3-month LIBOR rate of 5% (five percent) on the contract Settlement Date

As the LIBOR rate is higher than specified in the contract, Seller of the FRA owes the Buyer the difference between the 5% and the 4% interest on the Notional Amount for 90 days.

Forward Currency Contract / Forward Exchange Rate

This is an agreement to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date (or between two pre-defined dates rather than a single maturity date). The value of the forward is derived from the the spot price and the interest rate differentials between the two currencies (which allows for the adjust for the time value of money). A forward currency exchange contract can extend out in excess of one year.

The future value of currency is determined by:

FV=P(1+r)ⁿ

FV = Future value

P = Principal

r = interest rate per year

n = number of years

The future value of USD$ after one year when the interest rate is 3.250% is $1.03250 or FV=1(1+0.0325)¹

Forward Gold Market

A mine may know that they will produce a certain tonnage in the next six months. They could enter into a forward agreement to sell this gold when it became available. Thus, the company will lock in the present gold price and hedge a decline in the price, and know what their income would be when planning production.

Unlike a bond or a share, gold pays no interest or dividends. Starting from a neutral position the trader buys gold intending to sell it in one month. To buy the gold the trader has to borrow U.S. dollars (gold is quoted in dollars). When he sells the gold at the end of the month, he repays the loan, but he will be out of pocket to the extent of the interest charged on the loan. The price which he sells the gold at the end of the month must therefore be higher than the price paid for it to compensate the trader for the "cost of carry" which he has paid. That is why the forward price is usually higher than the spot price (premium).

A Commodity Non-Deliverable Forward is a forward contract that will be closed out and cash settled. The close out price can be based on an average price or can be negotiated between counterparties.