Forward Contracts Flashcards
What is a derivative?
A contract which involves two parties agreeing to a future transaction. Its value depends on (or derives from) the value of another underlying variable (e.g., price of a stock, price of hogs or amount of snow falling at ski resort).
What are the benefits of derivatives?
Short position: Benefit from a decline in the value of the underlying asset.
Leverage: Invest only a small amount of your own capital. Payment of margin/deposit upfront rather than the entire asset’s value.
Low transaction cost: Derivatives often have lower transaction costs than the underlying asset.
More liquidity: Derivatives markets tend to be highly liquid.
What are the primary uses of derivatives?
Hedging: Reducing the risk of potential future movements in a market variable.
Speculation: Betting on the future direction of a market variable.
Arbitrage: Taking offsetting positions in two or more instruments to lock in a profit.
What is a forward contract?
A forward contract is a non-standardised, privately negotiated OTC agreement between two parties to buy or sell an asset at a certain future time for a certain specified price (forward price).
What are some examples of types of forward contracts?
Commodity forwards
Foreign exchange (FX) forwards
Forward rate agreements (FRA)
What are the key differences between a forward contract and a future contract?
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.
Why does only one party have the motivation to default on a forward contract?
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.
Explain what happens when an investor shorts a certain share?
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.
What is a ‘zero-sum game’ of forward contracts?
Any gain realised by one party is exactly equal to the loss incurred by the other party. The profit of the long position equals the loss of the short position and vice versa. Therefore, the net payoff of both parties combined is always zero at contract maturity.
What is the value of the default risk in a forward contract?
The value of the winning position in the forward contract.
What is an FRA?
A forward rate agreement (FRA) is an agreement to exchange a predetermined fixed rate for a reference rate that will be observed in the market at a future time. Both rates are applied to a specified principal, but the principal itself is not exchanged. Only the difference due to different interest rates is paid.
What are the advantages of a long hedge using forwards?
- Purchase price is locked in
- 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
What are the disadvantages of a long hedge using forwards?
- 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
How may a company hedge against transaction risk?
Using a foreign exchange forward contract.
