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Lesson 2: Forward Contracts I Part 1
Forward Contract (Concept)
Forward Contract: An agreement to BUY or SELL an asset at a specified time (maturity or settlement date) in the future for a specified price.
The buyer of a forward contract agrees to pay a specified amount at a specified date in the future in exchange for a specified asset (called the "underlying"), such as currency, commodity, interest payment, bond, etc.
Example 2.1. (MPC):
On Jan 9, 2012, MPC agreed to take a delivery of 1 million barrels of crude oil on Sept. 1, 2012 at $100 a barrel from Exxon, regardless of the prevailing spot price on 9/1/2012.
- MPC is the buyer – the counter party taking a LONG position
- Exxon is the seller – the counter party taking a SHORT position
- The specified asset (commodity) is the crude oil, the specified time of the delivery date is 9/1/2012, and the specified price is $100 per barrel
- MPC will pay $100/bbl on 9/1/2012 regardless of the prevailing spot price
The exchange of the "underlying" and the "price" at the settlement time, T, can be viewed in the following figures:
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Commodity forward contract: the underlying is a commodity such as a certain amount of crude oil, gold, corn, etc. in exchange for an agreed price.
Figure 2.1. Commodity Forward Contract
FX forward contract: the underlying is the a fixed amount of foreign currency, such as 1 million yen, in exchange for an agreed price in USD.
Figure 2.2. Foreign Exchange Forward Contract
Interest forward contract: Receive the interest based on the spot LIBOR rate (floating rate is the underlying) at maturity on a notional principal of, let's say $10 million, and receive an agreed fixed rate of 5%.
Figure 2.3. Interest Rate Forward Contract