FuturesForwards - FORWARD AND FUTURES MARKETS The Basics of...

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1 FORWARD AND FUTURES MARKETS The Basics of Forward Contracts A forward contract is an agreement between two parties - a buyer and a seller - to exchange an asset at a certain future time for a certain price. The date at which delivery takes place is called the delivery date and the agreed-upon price is called the forward price . The contract can be viewed as a side bet on the future spot price. The payoff of this bet is equal to the difference between the forward price and the actual spot price that exists at the delivery date. The contract is simply a sale agreement established in an over-the-counter market in which delivery and payments are deferred. One of the parties to a forward contract assumes a long position and agrees to buy the underlying asset on a specific future date for a certain price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. The contract is usually between two financial institutions or between a financial institution and one of its corporate clients. A forward contract sounds a lot like an option. However, an option carries the right, not the obligation, to go through with the transaction. On the other hand, the two parties in a forward contract have the obligation to ultimately exchange the asset. Unlike options contracts, forward contracts are not normally traded on an exchange. They trade strictly in an over-the-counter market consisting of rather sophisticated communication channels among major financial institutions. An investor who considers the forward price to be very low might pay a premium to obtain such a contract. Conversely, if the forward price is considered too high, the contract has inherent value to the seller. Clearly, there is some intermediate price at which the contract will carry zero value. The price corresponds to the forward price. Thus, when a contract is initiated, the forward price is set such that there are no initial cash flows between the parties of the transaction and the value of the forward contract to both parties is zero. This means that it costs nothing to take either a long or a short position. Example Consider a cereal maker who requires rye in six months and is concerned that prices of rye will rise in the interim. To remove the price uncertainty the cereal maker decides to enter into a forward contract with a particular grain elevator operator. The two parties enter into a contract that specifies the price per bushel that the cereal maker will pay to the grain elevator upon receipt of the agreed-upon quantity at the scheduled delivery date. The quality of the rye that is to be delivered is also specified. The contract may permit some flexibility in the delivery schedule, perhaps allowing the grain elevator operator to dictate the exact day of a specified week for physical delivery to actually take place. Since the contract is a specific contract between two parties, the exact terms are negotiated to meet their particular needs.
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This note was uploaded on 08/28/2008 for the course FIN 545 taught by Professor Rahman during the Summer '08 term at Portland State.

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FuturesForwards - FORWARD AND FUTURES MARKETS The Basics of...

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