Forward

1. Derivatives
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2. 2
Introduction to Derivatives
• A derivative is a financial instrument whose value is derived
from the price of a more basic asset called the underlying
asset.
• whose payoff is explicitly tied to value or price of other financial
security
• that determines value of derivative is called underlying security
• arise when individuals or companies wish to buy asset or commodity
in advance to insure against adverse market movements;
• effective tools for hedging risks – designed to enable market
participants to eliminate risk.
• Settles on a future date
• Requires no or minimal initial investment
• Example:
• An exporter can fix a foreign exchange rate even before beginning to
manufacture product, eliminating foreign exchange risk.

3. Forward Contracts
• Forward contract is specified by a legal document, the terms of which bind two parties
involved to a specific transaction in the future.
• Holder of forward contract is obliged to trade at maturity of contract
• Unless the position is closed before maturity, the holder must take possession of the
commodity, currency or whatever is the subject of the contract, regardless of whether the
price of the underlying asset has risen or fallen
 on a priced asset is a financial instrument, since it has an intrinsic value determined
by the market for underlying asset
 on a commodity is a contract to purchase or sell a specific amount of commodity at
specific time in future at a specific price agreed upon today
• Contract is between two parties, buyer and seller.
 buyer (long ): obligated to take delivery of asset & pay agreed-upon price at maturity
 seller (short): obligated to deliver asset & accept agreed-upon price at maturity
• Claims are settled at defined future date; both parties must carry out their side of
agreement at that time.
• Forward price applies at delivery, negotiated so that initial payment is zero.
• The conventional way to express this is (use continuous compounding)
( )
F S e r d T
= -
0
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4. Forward Contracts
• Forward contract is specified by a legal document, the terms of which bind two parties
involved to a specific transaction in the future.
• Holder of forward contract is obliged to trade at maturity of contract
• Unless the position is closed before maturity, the holder must take possession of the
commodity, currency or whatever is the subject of the contract, regardless of whether the
price of the underlying asset has risen or fallen
 on a priced asset is a financial instrument, since it has an intrinsic value determined
by the market for underlying asset
 on a commodity is a contract to purchase or sell a specific amount of commodity at
specific time in future at a specific price agreed upon today
• Contract is between two parties, buyer and seller.
 buyer (long ): obligated to take delivery of asset & pay agreed-upon price at maturity
 seller (short): obligated to deliver asset & accept agreed-upon price at maturity
• Claims are settled at defined future date; both parties must carry out their side of
agreement at that time.
• Forward price applies at delivery, negotiated so that initial payment is zero.
• The conventional way to express this is (use continuous compounding)
( )
F S e r d T
= -
0
4

5. Commodity Forwards
• owner of commodities has to maintain their value, requires storage (wheat,
gold), feeding (live hogs), or security (gold) cost is called cost of carry
expressed as an annual percentage rate q.
• It is treated as a negative dividend.
• the valuation formula for commodity forwards is obtained as
T
q
r
e
S
F )
(
0

=
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6. Future
• A future contract is a standardized forward contract. It is also an
agreement between two parties to buy/sell an asset at a certain time in
the future for a certain price.
• The difference between a forward and a futures contract is that futures
contracts are traded on an exchange and a futures contract has
standard features to facilitate trading.
• Basically exchange-traded forwards
• Standardized terms
• Traded electronically or via open outcry
• Clearinghouse matches buys and sells, keeps track of clearing
members
• Positions are marked-to-market daily
o Leads to difference in the prices of futures and forwards
• Liquid since easy to exit position
• Mitigates credit risk
• Daily price limits and trading halts
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