An introduction to Forward Contracts

Consider a scenario in which an Indian software major is expecting a 100 million USD payment from one of its biggest US clients on the 1st of August. Even if the payment is assured, the software firm faces foreign exchange risk (also called forex risk or exchange rate risk or currency risk) i.e. the risk that USD may depreciate vis-a-vis the INR and the 100 m USD which is worth 4.6 billion INR (since 1 USD =46INR at the time of writing) today may reduce in value to say, 4.3billon INR (or even lower) by the date of receipt of the USD payment. The company can eliminate its risk if it enters a forward contract to sell 100 m USD on August 1 at a fixed price. This fixed price at which the company can sell the USD at the forward date will typically be close to price of the USD at the day when the contract is made. This is due to arbitrage (we will look at arbitrage a little later in this post). Let’s say the price at which the contract in question is made is 46.5 .The counterparty (i.e. in this case the party which agrees to buy the pre-specified amount of USDs at the pre-decided rate on the contract settlement/expiry date) may have entered the contract for one of the following 3 different reasons-
1) It wants to shield itself from the currency risk it faces, for instance it expects an INR payment in the month of July, which it wants to convert to 100 million USD to import expensive machinery from the US. It like the software major is concerned with the exchange rate it will face when it needs to convert the rupees to USD.
2) It expects the USD to trade higher than 46.5 INR at the day of the contract settlement (i.e. contract expiry) so that it can immediately sell the dollars bought at 46.5 for a profit on the day of expiry.
3) In order to profit from arbitrage.
The party which has agreed to buy the asset (here USD) is said to be holding a “long” position on the asset whereas the party which has agreed to sell the asset is said to be holding a “short” position on the asset. If the party has entered the contract to insulate itself from the asset (here USD) price risk it faces, it said to be “hedging” against the risk. Thus while the software firm is engaging in “short hedging” the counterparty is engaging in either “long hedging”(if it has entered the contract for reason 1) or speculation(i.e if it has entered the contract for reason 2). If the party enters the contract to profit from difference between the price agreed upon in the contact and the price of the asset on the day of the expiry, there is a probability that it suffers a loss, if the asset price moves in the direction adverse to which the party expected it to move (i.e. if in the present example the dollar rather depreciating, appreciates versus rupee to a value of say say 42.5 per USD).

A company like Indigo which is doing exceedingly well on operational parameters, will surely not like to make a loss just because it had to purchase Air Turbine Fuel (ATF) at a very high price due to the spiralling oil prices. It in this case it will probably enter a series of long contracts on the ATF (depending upon its future fuel requirements), whereas and oil refiners like RIL may choose to enter the contract on ATF on the short side thereby securing the right to sell the produce at a fixed price.

Contract Settlement

There are two major ways in which a forward contract may be settled on the expiry date
1) Delivery- The short delivers the pre-specified quantity of the asset to the long for the pre-agreed payment on the contract settlement date.
2) Cash settlement – This is the most commonly way to settle the contract if both the parties to the contract are speculating. In this type of settlement the disadvantaged party simply makes a cash payment to the gaining party on the contract settlement date i.e neither of the parties is actually interested in buying/selling the asset but simply want to gain from correctly predicting the direction of the price movement. Suppose two parties enter a contract to buy/sell 100kgs of rice at Rs 35 per kg on a future date. If the price of 1kg of rice on the settlement date is Rs 38, the long party’s right to buy the rice at Rs 35, confers a positive value to the party and an equal negative value to the short. If the long buys rice at Rs 35 and sells them at Rs 38 in the market , it will gain Rs (38-35)*100=300 and the short loses an equal amount , having to buy rice at rs 38 to eventually sell them at Rs 35.i.e short party’s loss is Rs(35-38)*100 =-300. So the parties instead of buying/selling the asset can simply exchange a sum of Rs 300 to settle the contract.
Contract Offsetting –Assume that a party assumes a long position in a forward contract to buy 1000kgs of a particular variety of wheat on the 15th Sept at the rate of Rs 10 per kg (the market rate of the wheat being Rs 9.8/kg). Subsequent to the entry in the contract the asset price starts falling, and the speculator looking at market conditions and other factors decides that the price should fall further by the expiry of the contract. To limit their losses the party can enter an offsetting contract.

The quantity and quality of the asset and the date of expiry of the contract will be the same in both the offsetting and the original contract. The difference being that the party assumes a reverse position (i.e. short position in this case) in the offsetting contract and the offsetting contract confers a right upon the parties to buy/sell the asset albeit at a different price than specified in the original contract. Let’s suppose the contract is to buy/sell a kg of wheat at Rs 8(when the prevailing price is Rs 7.9/kg). Now the party has a short position in the offsetting contract and long position in the original contract. This way the party has locked in a loss of Rs 2 per kg. Let’s see how. At expiry if the price of a kg of wheat is Rs 20, the right to buy wheat at the rate of Rs 10 per kg has a value of (20-10)*1000=10000 and the right to sell wheat at Rs 8 has a value of Rs(8-20)*1000=-12000, thus in totality both the rights have a value equal to -2000 .i.e a loss of 2 rupees per kg, this is true for irrespective of the spot price of wheat at the time of expiry. Another way to look at this is to consider that the party has a right to buy 1000kg of rice for Rs10000 and is required to sell those 1000kgs at Rs8000, thus incurring a loss of Rs 2000.

Hedging( whether long or short ) is of course not without its costs, a company like the software major above , is required by the contract terms to sell the dollars at a pre-agreed price, even if the prevailing price is much higher than this pre-agreed price. A long hedger on the other hand has an obligation to buy the asset at the predetermined price even if the asset is trading at a much lower price in the market at the time of contract settlement.

Default Risk
An unscrupulous party may however choose not to perform as per the terms of the contract, for instance a the party holding the long position (sometimes simply called the “long”) may choose not to perform if the free market price of the asset is lesser than the price it has agreed to buy upon as per the contract. Similarly, the short may breach the contract if it can sell the asset at a price higher than stipulated in the contact. The risk a party faces due to possible non performance of a disadvantaged counterparty is termed as the default risk. The most commonly appointed measure to reduce (if not totally eliminate) the default risk is to sign up a trusty third party dealer. When the two parties sign up the contract the parties deposit some amount of money with the dealer as a guarantee of performance.

Arbitrage
Apart from speculation and hedging there is a third reason as to why a company many choose to enter a forward contract. Suppose that the current exchange rate of the USD is 46 rupees. The price at which at asset can be currently bought or sold is called the spot price of the asset. The price at which the asset can be bought or sold in the future is called the future price. Suppose the Future price of USD for August 1 delivery is 47 INR. A party wanting to profit from arbitrage will buy the USDs now and sell them at the contract price on the contract settlement date (i.e buy at 46 now and sell at 47 on the contract settlement date). Such arbitrage opportunities and the consequent buying support for the USD will tend to increase the demand for USDs and hence will tend to increase the USD price to the point where spot prices and the future price become equal and the arbitrage opportunities are effectively eliminated. There are two potential barriers to arbitrage
1) The transaction costs may be so high that they effectively nullify the possibility of profiting from the price difference.
Before we discuss the 2nd factor that makes arbitrage ineffective let’s discuss what is the Risk Free Rate. In order to meet their financial obligations governments around the world issue bonds. Buying (or investing in) such a bond is considered akin to lending money to the government, i.e. the government’s promise to pay a fixed rate of interest to the bond holders (“the borrowers”) and the principal upon bond expiry/maturity. Now it is very unlikely that the government will default on its obligation to pay the bond holders the promised interest and principal payments. Therefore these bonds which can be issued for various durations and carry different rate of interest depending upon the duration for which they are issued are regarded to be free of default risk. While this assumption may be true in normal circumstances, the bonds issued by an economy in a bad shape like that of Greece (where Debt/GDP ratio is greater than 1) is regarded to be carrying a good degree of default risk. The debt issued by various companies is generally considered less safe than government issued debt and is thought to be having various degrees of default risk. How much risk the company’s debt obligations carry is determined by its business position, ability and credibility of its management, past payment record etc. Determination of the degree of risk is a task best left to the credit rating agencies like Moody and Fitch in the US and ICRA and CRISIL in India. The greater the default risk of the bond the greater is the interest rate required by the investors to invest in such a bond.
So much for the Risk free rate (RFR), let’s come to second hurdle against arbitrage. As discussed above forward contracts carry default risk. So if the returns from arbitrage are less than the returns on the government bonds (i.e. the RFR), the sane investors instead of attempting to profit from arbitrage will invest at the RFR in the government bonds. It is therefore true that greater the time to expiration of the contract, greater is the potential price difference between the future price and the spot price.
There are other derivative instruments available in the market apart from forwards. In one of the subsequent posts we will cover two such instruments namely futures and options .Happy Reading!