Forward Contracts

Forward Contracts - Florence, Italy
Forward Contracts

A forward contract is a contract between a buyer (long position) and a seller (short position) in which the buyer agrees to buy and the seller agrees to sell a specific quantity of a security or commodity (known as the underlying asset) at the price specified in the contract.

Agents must define a notional value to arrange the payment to make or to receive, but no capital payment is due to the counterpart. The underlying assets can be an interest rate, an exchange rate, a bond, a stock, an index, or a commodity.

Because the forward contract is privately executed between the two entities, it is considered as an over-the-counter contract. In a forward agreement (i) the long position payoff at maturity is S(T) – K, where S(T) is the underlying asset price at maturity; and (ii) the short position payoff at maturity is K – S(T).

During its life, the forward contract assumes the value as follows:

For a long position

f = (F0 - K)e-rT

For a short position

f = (K − F0)e−rT

where K is the price at maturity, F0 is the actual forward price (i.e., the price of a forward is exactly the same as of the initial forward but traded at the valuation date), r is the continuously compounded rate, and T is the final date of the contract.

Some of the most important characteristics of the contract are as follows:
  • High flexibility, in terms of underlying asset, size, and delivery date
  • Counterpart risk
  • Gain/loss completely computed at maturity
  • Low secondary liquidity 
Agents can decide to operate in the forward market with the following three purposes:
  • Speculation, when positions depend on price expectations, with the risk to misinterpret the market dynamics
  • Hedge, when the evolution of the forward price protects from unexpected price movements of cash positions held in portfolio
  • Arbitrage, when it is possible to match two positions obtaining a gain for a price spread (assuming that the nonarbitrage condition holds, this opportunity fails)

Allaz and Vila (1993) put forward the reason of the existence of forward contracts even in a world without uncertainty. Many studies show the weakness of forward contracts to predict spot rates and prices.

In case of interest rates, Fama (1976, 1984) demonstrates that forward rates fail to forecast since they do not incorporate the term premium. Buser et al. (1996) show that adjusting for the premium, forwards are reliable predictors of future spot rates.

Forward contracts are frequently used to implement hedge fund strategies, which trade derivatives, take short positions, or gain from arbitrages. In particular, forwards are frequently used by global asset allocator (or macro) funds managers, who match long positions in undervalued investments and short forward positions in overestimated assets.