L6 - Introduction to Forwards

Question 1

What is a forwards contract?

Answer 1

• Definition: obligation to buy/sell underlying at a later date a price agreed upon today
• Uses: trading, hedging, arbitrage
• Forward prices (setting a future purchasing price) and forward market value

Question 2

Payoff diagram of a long forward position?

Answer 2

*

Question 3

Example of a Forwards contract with a physical delivery?

Answer 3

• actually receive the underlying (the 100s barrels of oil)

Question 4

Example of a forwards contract with a cash delivery?

Answer 4

• No exchange of barrels of oil but instead cash transfer of the different amount between the agreed forward price and the actual/spot price on the forward date

Question 5

What risk can arise when entering into a forwards contract?

Answer 5

• counterparty risk –> counterparty doesn’t have the ability to pay you the cash on the forward rate.
  
  • Before clearing houses - during the Lehman crisis - you could enter into a forwards contract with no capital as you don’t exchange any money till the forward date –> no need for margin at all
• market risk –> at maturity we don’t know what price will be

Question 6

What are the costs of entering a forwards contract?

Answer 6

• e.g. you as a retail client are making a contract with a bank as your counterparty
  
  • Financial cost –> this is 0 because we fix the forward price at the equilibrium –> same probability to make money and lose money
    
    • So the buyer and the sell are in the same position
  • Fee –> you have to pay for someone to explain to you the contract, someone calculating the forward price, the bank may be taking on the risk and need compensation to enter into the contract
    
    • This fee depends on the contract, is it based on a really specific underlying with some very specific characteristics –> you will pay more as your counterparty is taking on more risk

Question 7

How can we use a forwards contact for trading?

Answer 7

• trading you expectation of where the price of the underlying is going
  
  • don’t really care about receiving or doing anything with the underlying

Question 8

What is the difference between buying spot and buying forwards?

Answer 8

• What is the difference between buying spot and buying forward:before the leverage –> don’t need to pay immediately get to pay at the end –> the leverage effect
  
  • Although this is mitigated slightly by the fee you have to pay to hedge counterparty risk
  • true for any underlying
• buying spot of a commodity you will have to buy the physical oil - store it somewhere before you sell it
  
  • Occur storage costs, the risk falls on you as something could happen between now and the date you sell it
  • don’t have to deal with when trading forwards –> as you can just deal with a cash settlement at the end

Question 9

Why are forwards often not used for trading purposes?

Answer 9

• As they are OTC not trade in an exchange
  
  • As traders in derivatives assume short term liquid positions
  • But creating a OTC contract has to be done with a contract agreement with a counterparty (the process is too long and illiquid)
    
    • That also if you can find a counterparty to close you position with
    • There are exceptions e.g. exchange rate forwards –> so many player in this market you will almost always find a counterparty

Question 10

Example of a forwards contract used for hedging with a physical delivery?

Answer 10

• Airlines are exposed to the risk of changes in the price of oil
  
  • Usually, price and sell the tickets first before buying the oil
• So if the price goes up:
  
  • Pay more to buy the oil on spot but we receive more from our forward position
• if the price goes down:
  
  • Profit on the underlying (pay less) but make a loss on the forward contract
• no matter what the future spot price is you will pay the agreed price of the forwards contract to receive the oil

Question 11

Example of a forwards contract used for hedging with a cash delivery?

Answer 11

• As you need the oil
  
  • While you hedge the price with the forward’s contract –> receive the extra cash payment
  • You still buy the oil in the market at the future spot price
    
    • but as you have hedged the market risk you basically have paid for the barrels of oil at a price of 88.69 (using the money you receive from the forward’s contract)
• No matter what you fixed the future price you will pay
  
  • Hedging doesn’t mean you will make a profit –> it is just eliminating uncertainty
    
    • However if the underlying of the contract is volatile it might not be easy to predict the future spot rate and you cannot hedge away all risks

Question 12

Example of hedging wont always bring in profits?

Answer 12

Question 13

Short Forward position payoff?

Answer 13

• You are expecting the price to go down
• In this case, you can either short the forward or short-selling

Question 14

How can you use the short forward position for trading?

Answer 14

• entering into the contract to sell at 60

Question 15

How can a short forward position be used to hedge?

Answer 15