Forward contract: the basis of all derivatives

The most complex types of investment products usually fall into the broad category of derivative securities. For most investors, the concept of derivatives is difficult to understand. However, because government agencies, banking institutions, asset management companies, and other types of companies often use derivatives to manage their investment risks, investors must understand what these products represent and how investments use them. professional.

In fact, one of the oldest and most commonly used derivatives is forward contracts, which are the conceptual basis for many other types of derivatives we see today. Here, we carefully study forwarding and understand how they work and where they are used.

Key points

  • A forward contract is a customized derivative contract that requires the counterparty to buy (receive) or sell (deliver) assets at a specified price on a future date.
  • Forward contracts can be used for hedging or speculation, although their non-standard nature makes them particularly suitable for hedging.
  • In the foreign exchange market, forwards are used to take advantage of arbitrage opportunities at the cost of holding different currencies.
  • Understanding how forwards work can better understand more complex and subtle derivatives, such as options and swaps.

Transaction and settlement procedures

Forward contracts are traded on the over-the-counter (OTC) market, which means they are not traded on exchanges. When the forward contract expires, the transaction is settled in one of two ways. The first way is through a process called “physical delivery”.

Under this settlement method, the party with a long forward contract position will pay the party with a short position when the asset is actually delivered and the transaction is completed. Although the transaction concept of “delivery” is easy to understand, it may be very difficult for the party holding a short position to deliver the underlying assets. Therefore, forward contracts can also be completed through a process called “cash settlement”.

Cash settlement is more complicated than delivery settlement, but it is still relatively easy to understand. For example, suppose at the beginning of the year, a grain company agreed through a forward contract to purchase 1 million bushels of corn from farmers at a price of $5 per bushel on November 30 of the same year.

At the end of November, assume that the price of corn on the open market is $4 per bushel. In this example, a grain company that has long-term forward contract positions will receive assets from farmers that are now worth $4 per bushel. However, since the grain company was agreed at the beginning of the year to pay $5 per bushel, the grain company could simply ask farmers to sell corn on the open market at $4 per bushel, and the grain company would pay the farmers $1 per bushel in cash. According to this proposal, farmers will still receive $5 per bushel of corn.

On the other side of the transaction, the grain company only needs to buy the necessary corn on the open market for $4 per bushel. The net effect of this process is that the grain company pays farmers $1 per bushel of corn. In this case, the sole purpose of cash settlement is to simplify the delivery process.

Currency forward contract

The forward contract can be customized to make it a complex financial instrument. You can use currency forward contracts to help illustrate this point. Before explaining currency forward contract transactions, we must first understand how currencies are quoted to the public and how institutional investors use them for financial analysis.

If a tourist visits Times Square in New York City, he is likely to find a currency exchange office that shows the exchange rate of foreign currencies against the U.S. dollar. This type of convention is often used. It is called an indirect quotation, and it may be the way most retail investors think about trading currencies.

However, when institutional investors conduct financial analysis, they use the direct quotation method, that is, the number of domestic currency units per unit of foreign currency is indicated. This process is established by analysts in the securities industry, because institutional investors tend to consider the amount of domestic currency required to purchase a unit of a particular stock, rather than how many stocks can be purchased for a unit of a particular stock. National currency. In view of this customary standard, direct quotes will be used to explain how to use forward contracts to implement an interest-covered arbitrage strategy.

Suppose an American currency trader works for a company that often sells products in Euros in Europe, and these Euros eventually need to be converted back to U.S. dollars. Traders in such positions may know the spot and forward exchange rates between the U.S. dollar and the euro on the open market, as well as the risk-free rate of return of the two instruments.

For example, currency traders know that the spot exchange rate of USD per euro on the open market is 1.35 USD per euro, the annual risk-free interest rate in the United States is 1%, and the annual risk-free interest rate in Europe is 4%. The one-year currency forward contract on the open market is quoted at $1.50 per euro. Armed with this information, currency traders can determine whether there are guaranteed interest arbitrage opportunities and how to establish a position to earn risk-free profits for the company by using forward contract transactions.

Covers interest arbitrage strategies

To initiate a secured interest arbitrage strategy, currency traders first need to determine what the forward contract between the U.S. dollar and the euro should be in an effective interest rate environment. To make this decision, the trader divides the spot exchange rate for USD per euro by the European annual risk-free interest rate, and then multiplies the result by 1 plus the US annual risk-free interest rate.

[1.35 / (1 + 0.04)] x (1 + 0.01) = 1.311

In this case, the one-year forward contract between the U.S. dollar and the euro should be sold at a price of $1.311 per euro. Since the price of one-year forward contracts on the open market is $1.50 per euro, currency traders will know that forward contracts on the open market are overpriced. Therefore, savvy currency traders will know that anything that is overpriced should be sold for profit. Therefore, currency traders will sell forward contracts in the spot market and buy euro currency to obtain a risk-free rate of return investment.

example

The interest-bearing arbitrage strategy can be implemented in four simple steps:

step 1:

Currency traders need to take 1.298 US dollars and use it to buy 0.962 euros.

To determine the amount of dollars and euros required to implement an interest-bearing arbitrage strategy, currency traders divide the spot contract price of $1.35 per euro by the 4% European annual risk-free interest rate.

1.35 / (1 + 0.04) = 1.298

In this case, $1.298 is needed to facilitate the transaction. Next, the currency trader will determine how many euros are needed to facilitate the transaction, which is simply determined by dividing by 1 plus the European 4% annual risk-free interest rate.

1 / (1 + 0.04) = 0.962

The required amount is 0.962 Euro.

Step 2:

The trader needs to sell a forward contract to deliver 1.0 euro at the end of the year at a price of 1.50 US dollars.

Step 3:

Traders need to hold positions in Euros this year and earn interest at the 4% European risk-free interest rate. The value of the position will increase from 0.962 Euro to 1.00 Euro.

0.962 x (1 + 0.04) = 1.000

Step 4:

Finally, on the expiry date of the forward contract, the trader will deliver 1.00 Euro and receive 1.50 USD. This transaction is equivalent to a risk-free rate of return of 15.6%, and the appropriate unit of rate of return can be determined by dividing $1.50 by $1.298 and subtracting 1 from the sum.

(1.50 / 1.298) – 1 = 0.156

The mechanism of this interest-bearing arbitrage strategy is very important to investors because they explain why interest rate parity must always remain true to prevent investors from obtaining unlimited risk-free profits.

Covered interest arbitrage

Forward market opacity

Forward provides buyers and sellers with a certain degree of privacy, and can be customized to meet the specific needs and intentions of buyers and sellers. Unfortunately, due to the opaque nature of forward contracts, the size of the forward market cannot be accurately known. In turn, this makes the scope of the forward market more difficult to understand than some other derivatives markets.

Due to the lack of transparency in the use of forward contracts, some potential problems may arise. For example, parties using forward contracts face the risk of default. Due to the lack of a formal clearing house, their transaction completion may have problems. If the derivative contract structure is improperly structured, they may face huge losses.

Therefore, serious financial problems in the forward market may spread from all parties involved in such transactions to the entire society.

Up to now, serious problems such as systematic breach of contract by the parties to the forward contract have not been resolved. Nevertheless, as long as large organizations are allowed to undertake forward contracts, the economic concept of “too big to fail” will always be a problem. This problem becomes even more worrying when considering both the options and swap markets.

Forward contracts and other derivatives

As described in this article, forward contracts can be customized as very complex financial instruments. When considering the different types of basic financial instruments that can be used to implement forward contract strategies, the breadth and depth of these types of contracts will increase exponentially.

Examples include fixed-income forward contracts using stock forward contracts, treasury bills and other securities on individual stock securities or index portfolios, and interest rate forward contracts with interest rates such as the London Interbank Offered Rate (LIBOR), which are used as forwards in the industry Interest rate agreement.

Finally, investors should understand that forward contract derivatives are often regarded as the basis of futures contracts, options contracts, and swap contracts. This is because futures contracts are basically standardized forward contracts with formal exchanges and clearing houses.

Option contracts are basically forward contracts that provide investors with the option to complete the transaction at a certain point in time, but it is not an obligation. A swap contract is basically a chain-link agreement of a forward contract, which requires investors to take regular actions over time.

Bottom line

Once they understand the connection between forward contracts and other derivatives, investors can begin to realize the financial instruments they can use, the impact of derivatives on risk management, and the potential scale and importance of the derivatives market to many government agencies. sex. Institutions, banking institutions and companies around the world.

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