Forward- Introduction
Definition: Agreement between two parties viz buyer and
seller , calling for delivery of a specified asset at specified price on future date Legally bound contract- specified amount of a underlying asset should be settled against money- buyer and seller Cable TV example Spot price- price paid immediately towards the delivery of the asset Forward price price agreed to buy or sell at pre determined rate during the future
Forward as zero sum game
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Classification of Forward contracts Forward contracts regulation act-1952
Hedge contracts
Transferable specific Forward contracts Delivery forward contracts Non transferable specific delivery forward contract
Hedge forward contracts
Freely transferable contracts
No specification of lot sizes,
quality or delivery standards of underlying assets Physical delivery of contracts
Delivery forward contractsFCRA-1952
Freely transferable contracts
Specific and predetermined lot size and
variety of the underlying asset Compulsory delivery of underlying at the
expiration date-exemption to Govt
Non transferable specific delivery forward contract
Exempted from the provisions of Act 1952 Cannot be transferred to another party Contract, consignment lot size and quality of
underlying asset settled at expiration date
Non deliverable forward contract
No delivery will take place between parties
Cash system of settlement will take place on maturity SBI example-Chinese yuan Cash system- (Forward rate-Spot rate)*Notional
amount
Terminologies used Underlying asset
Long position Short position Spot price Future spot price Expiration date Delivery price
Features of forward contract
Bilateral negotiated contract-counter party
risk . Each contract- custom designed :contract terms ,size ,quality,asset type, expiration date etc In delivery or cash on expiry date Contract price not available to public domain Wishes to reverse the contract-subject to the counterparty-high prices
Forwards Vs Futures
Forwards Private contracts-bilateral Futures Through organised exchanges
Customised One specified delivery date Settled at the end of maturity More than (90 percent) contrats physical delivery
Delivery or final cash settlement takes place No margin money required Cost of forward contracts-bid & ask spreads Credit risk
Standardised Multi delivery dates Daily settle method 5 percent of contracts by the delivery
Contracts closed out price to the delivery Margins required Brokerage fee for buy or sell orders Reducing credit risk
Advantages To hedge or lock in the price of purchase or
sale of underlying No upfront margins Price risk exposure -100% could be hedged
Disadvantages
Lack of standardisation no uniformity (3) Counterparty risk- Default risk from the counterparty- Risk of Non performanceEgypt example Lack of liquidity- due to non standardisationlack of tradability -problem of supply due to flood
Forward range contracts
Instead of using single rate in the forward
contract-multiple rates are . 1$=Rs47-49-flexible forward contracts Spot rate (maturity)with in Rs.47-49 spot rate is used Other wise higher than Rs.49 Less than Rs.47
Forward contract mechanism
Mr. X wholesale sugar dealer and MrY is the
prospective buyer . The current price (on 1st April,2010) of sugar per Kg is Rs.23. Mr Y agrees to buy 50 kgs of sugar at Rs.30 per kg after three months(1st July.2010) If price is Rs.40 who is the gainer If price is Rs.20 who is the gainer
Forward contract mechanism
60 50 40 30 Seller Rs 20 10 0 1 2 3 4 5 6 Price of the underlying asset at maturity Buyer Rs
Forward price premium, discount
Forward price spot price if FP > SP premium
Forward price- spot price if FP<SP discount Determinants of Premium /Discount Interest rate fluctuations Market forces Anticipated demand and supply
Pricing of Forward contract
F-S(1+r) An assumption of no money at the beginning
and end F-S(1+r)=0 F=S(1+r) or P0+C=>??? Cost of carry => percentage of the spot price
Gain on long position
F1 T =Forward
price at the time of entering into the contract that expires T St=Spot price at enter period ST = Spot price at T (expiration of the contract) K= Delivery price
=Number of units(ST - K orF1T)
Gain on short position
=Number of units (Future spot price-Futures spot price
or Delivery price)
Number of units (K orF1T-ST)
Forward rate agreement Interest rate forward
Planning to borrow after some time or
the firms using floating rate of interest to hedge
against interest rate risk Users : Both corporates and Banks to mitigate the interest rate fluctuations What FRA does? Does it change the principal ? It locks the interest rate For what reasons FRAs are considered?
Forward rate agreement
Loans =>base rate eg:MIBOR,prime rate Interest rate on the loans=>Base rate+premium
(riskiness of the project)i-e 200 basis points ->Known as fixed ;but base subject to volatile expected to change Three important periods of FRAs Time which FRA is entered into finalisation of terms of agreement FRA settlement period-FRA steps into operation-on this date borrowing is taking place- exchange of cashflows will takeplace End of exposure date :borrower either repay loan or no longer the hedge is required
FRA-example
FRA-Settlement and End of Exposure date .eg-30*210
Settlement on 30 day from the time of agreement Exposure end date -210days hedge lasts upto 180 days
Forward rate agreement
Two parties are involved banker and customer
(customer of the other banker) One party agreed- to pay the guaranteed rate of interest to another to cover specified sum of money in specified future Buy FRA no actual borrowing / lending is taking place At the time of maturity ,if FRA< market rate of interest-banker will pay the interest FRA> market rate of interest customer
Forward rate agreement problem
On January 1, the finance manager of Maruti forecasts
that Maruti will need INR 10,000,000 on March 1. Since the interest rate at which Maruti can borrow the amount on March 1 is not known on January 1, Maruti faces an interest rate risk and would like to enter into a forward contract that will fix the interest rate on Jan 1 for the loan that will be taken on March 1 . Since the borrowing is on March 1 , which is 59 days from January 1 and the exposure is on August 31, which is 243 days from January 1 , this will be known as a 59*243 FRA
FRA -Problem Consider the case of Bengal Corporation , which plans
to borrow money after 30 days for a period of 180 days . Since the money is being borrowed after 30 days , the borrower faces uncertainty of knowing interest what interest will be on 180 day loan when the loan is taken after 30 days. Thus it will enter into a 30-day FRA . The AR is 8% , the RR is the MIBOR and the cost of loan is MIBOR+200 basis points Since the FRA is 30 day/210 day, the interest rate which is of concern is the RR after 30 days . Assume that the 180 day MIBOR after 30 days is 7% . Then the RR will be 7%+2%=9% ; AR=8% If the MIBOR is 5% i-e RR is 7% Notional principal Rs.1,000,000
Sale of FRA-Deposits If FRA<market rate of interest Customer will
compensate If FRA>market rate of interest Banker will compensate Purchase of FRA- protect the interest against rise in interest borrowing from the bank. Sale of FRA-protect the interest against fall in interest deposits point of view .
Hedging & Speculation
Risk management Hedging Exporter- forward contract to sell Importer forward contract to buy Speculation Long position to buy /sell
Example
Spot market Rs.4800 per 10 gms
Rf:8% What is reasonable price of one year forward contract? Borrow Buy- Sell forward not less than at what ? If spot price is equivalent to forward price ? Hold sell- Long forward contract
