Forward Contract
Foreign Exchange Currency
Bid (Buy) Offer (Sell)
Spot Price 278.5 279.5 Seller/Exporter
1-Month Forward 278 278.25
3-Month Forward 277 277.5 Spot
6-Month Forward 280 280.5 6 Month
Hedge the risk = Hedging
- Financial Strategy
- Protects an individual finances from being exposed to a risky situation that may lead to loss of value
- Win or Loss both may be occurred
Importer
Examples of Hedging
Bank
1- Diversification
Donot put your all eggs in one basket Exporter
2- Arbitrage
It involves buying a product from one market and selling it immediately in another market for a higher profit; thus,
3- Average Down
1-Oct Buy LUCK 900
10-Oct 850
15-Oct 825 Loss Quantity Total Loss Cost
17-Oct 820 -80 1000 (80,000) 1-Oct
17-Oct Buy LUCK @ 1500 820 17-Oct
Average
25-Oct 860 8 2500 20,000
27-Oct 870 18 2500 45,000.00
4- Staying In Cash
The investors keep part of his money in cash, hedging against potential loss in his investment
Relationship between Forward Price and Spot Price
Forward Price = K
Spot Price = St
Buyer - Long Position PV 100000
St - K r or i 10%
n 2 year
Seller - Short Position FV = PV (1+r)^n
K - St FV = 100000x(1+10%)^2
FV = 121000
Example
Stock Price (Spot Pric 60 with no dividend
Interest Rate 5%
After 1 Year
Forward Price 67
Long Vs Short
Forward Price > Spot Price =====> LONG POSITION
Buy the stock
Quantity 2000 shares
Money Required 2000*60 120000
Step#01 Loan Taken @ 5% 120,000 cash inflow
Step#02 Purchase the stock 2000*60 120000
Step#03 Purchase the forward contract @ 67
Step#04 After 1 year
Stop#05 2000*67 134,000 134000
Profit 14,000 -120000
Less: Interest Expens 120000*5 (6,000) -6000
8,000 8000
Forward Price < Spot Price =====> SHORT POSITION
Forward Price = 58
Spot Price = 60
Step#01 Sell the Stock @ 60 (Quantity = 2000) 120,000
Step#02 Buy the forward Contract @ 58
Step#03 Invest the amount received from selling of stock @ 5%
Step#04 After 1 year, return from investment
120000*5% = 6000 + 120000 = 126000
Step#05 Purchase the stock at 58
2000 x 58 = 116000
Step#06 Profit = 126000 - 116000 = 10000
Less: Expenses -1500
8500
Risk Associated With Forward Contracts
1- Counterparty Risk
OTC Buyer and Seller (Negotiate the terms)
Either party does not fulfill his/her obligation
Minimize?
1- Default Risk
2- Performance Bond
Guarantee ===guarantor (third party such as insurance company)
3- Collateral
2- Market Risk
Price Fluctuation
up long profit
down long loss
up short loss
down short profit
Minimize?
Cost 265
Sell $1 278.5
Profit 13.5
Book $1 at RS 280
Profit 280-265 = 15
loss of value
3 month $7,000 280
2 Per $
3 month $8,000 278
ket for a higher profit; thus, making small but steady profits
1000 900 900,000
1500 820 1,230,000
2500 2,130,000
Rate = Total Cost = 2,130,000 852
Total Shares 2500
