Derivatives form a vast category of rather complex investment products. Most investors have difficulty understanding the derivative instrument concept. But it is important for them to gain general knowledge of these products, because derivatives are used by corporations, asset management companies, governmental agencies, and banking institutions. It is crucial to understand how these instruments are used by investment specialists.
Let us examine one of the most common and oldest derivatives, the forward contract. It is the conceptual basis for a host of other derivatives in use nowadays. Below we will dwell at forward contracts, or forwards, on where they are used, and on how they work.
The Key Points
- A forward contract is a derivative contract customized and imposing the obligation on counterparties to purchase or sell an asset on a specific future data and at a specified price.
- A forward contract is suitable for use in hedging or in speculation. It is particularly useful for the former, because it is non-standardized.
- On Forex markets, forwards are tools for exploiting arbitrage opportunities in the cost of carrying different currencies.
- The understanding of how forwards work can help for deeper understanding of other, more complex derivatives such as options and swaps.
Trading and Settlement Procedures
The trading of forward contracts is done over-the-counter, rather than on an exchange. After the expiry of a forward contract, there are two ways to settle the transaction.
The first one is the so called “physical delivery”. In it, the party which is long the forward contract pays the other party, which is short the position. The payment is done when the asset is delivered, so the transaction is finalized. The concept of delivery is easily understandable, but there may be difficulty for the party which is holding the short position to implement the underlying asset delivery. Thus the completion of a forward contract can be implemented via “cash settlement”.
The cash settlement is more complex compared to a delivery settlement, but is relatively easy to understand. Here is an illustrative example.
At the year start, a cereal company signs a forward contract and agrees to purchase corn on November 30 from a farmer; the amount is 1 mln bushels, at $5 per bushel.
If at the end of November the price of corn is $4 per bushel on the open market. The cereal company is long the forward contract position, and is due to receive an asset from the farmer at a worth of $4 per bushel. But at the year start the agreement was that the company would pay $5 per bushel. The cereal company could ask the farmer to sell the corn amount on the open market, at $4 per bushel; the cereal company would pay the farmer in cash $1 per bushel. The farmer would still finally get the $5 per bushel for the corn.
As for the other side of the transaction, the cereal company would buy the bushels on the open market, for $4 per bushel. The net effect would be the payment to the farmer by the company of $1 per bushel. This is a cash settlement, used solely to simplify the delivery process.