Thursday, 28 November 2019

Unit 3: Introduction to Forward Contracts


                           Unit 3: Introduction to Forward Contracts   

A Forward Contract is a contract made today for delivery of an asset at a pre-specified time in the future at a price agreed upon today.

Unlike future contracts, they are not traded on an exchange, rather traded in the over-thecounter market, usually between two financial institutions or between a financial institution and one of its clients.

They are over-the-counter (not traded in recognised stock exchanges) derivatives that are tailored to meet specific user needs.

Forward contracts are bilateral contracts, and hence, they are exposed to counter party risk.

Financial Derivatives    Also, since the contracts are not exchange-traded, there is no marking to market requirement, which allows a buyer to avoid almost all capital outflows initially (though some counterparties might set collateral requirements).

Given the lack of standardisation in these contracts, there is very little scope for a secondary market in forwards.

The price specified in a forward contract for a specific commodity.

The forward price makes the forward contract have no value when the contract is written.

The forward market is like a real estate market in that any two consenting adults can form contracts against each other.

This often makes them design terms of the deal which are very convenient in that specific situation, but makes the contracts non-tradable.

Delivery Price: The pre-specified price of the underlying assets at which the forward contract is settled on expiration is said to be delivery price.

Economic exposure: Economic exposure refers to the impact of fluctuations in financial prices on the core business of the firm.

Forward Contract: A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today.
(E.g.forward currency market in India).

Future Spot Price: This is the spot price of the underlying asset on the date the forward contract   expires and it depends on the market condition prevailing at the expiration date.

Long Position: The party that agrees to buy an underlying asset (e.g. stock, commodity, stock index, etc.) in a future date is said to have a long position. Short Position: The party that agrees to sell an underlying asset (e.g. stock, commodity, indices, etc.) in future date is said to have a short position.

Transactional risks: Transactional risks reflect the pejorative impact of fluctuations in financial prices on the cash flows that come from purchases or sales.

Transferable Specific Delivery (TSD) contracts: These are contracts, which, though freely transferable from one party to another, are concerned with a specific and predetermined consignment or variety of the commodity.

Translation risks: Translation risks describe the changes in the value of a foreign asset due to changes in financial prices, such as the foreign exchange rate.

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