Good day everyone. You won't get bored with my work. Especially after we started collaborating with foreign clients. Just returned from China just yesterday. The country is interesting, but there was no time to get to know it.
I had to work hard on one transaction according to a special scheme. Now you will understand everything. So, forward contracts are the topic of our discussion today.
I will show you all the ins and outs of such transactions. Therefore, let’s begin the analysis without delay, dear readers!
Forward Contract and Price: Definition and Examples
A forward contract is a futures contract that is usually concluded outside of an exchange. This is an individual contract that meets the needs of counterparties.
It is concluded to carry out the actual sale or purchase of the underlying asset and insure the seller or buyer against possible adverse price changes.
Concluding a contract does not require any expenses from counterparties (here we do not take into account possible overhead costs associated with completing the transaction, and commissions if it is concluded with the help of an intermediary).
The contract is executed in accordance with the conditions that were agreed upon by the participants at the time of its conclusion.
Example 1. On April 30, person X entered into a forward contract with person Y for the delivery of 100 shares of company A on September 1 at a price of 100 rubles. for one share. In accordance with the terms of the contract, person X will transfer 100 shares of company A to person Y on September 1, and person Y will pay 10,000 rubles for these securities.
A forward contract is a firm transaction, i.e. a transaction that is binding.
A person who undertakes to buy the underlying asset under a contract opens a long position, i.e. buys a contract. The person selling the underlying asset under the contract opens a short position, i.e. sells the contract.
The subject of forward contact can be various assets. However, in world practice, the forward foreign exchange market has become the most widely developed, and forward contracts are actively used to hedge currency risk.
Here are examples of insuring currency risk using a currency forward.
Example 2. The importer plans to buy goods abroad in three months. He needs currency. To play it safe, he decides to hedge the currency purchase with a three-month forward on the US dollar.
Banks offer three-month contracts at a price of 1 dollar = 30 rubles. The importer buys a contract at this quote, i.e., enters into a contract with the bank, under which he undertakes to buy dollars.
Three months pass, the importer pays 30 rubles under the contract. for one dollar and receives the contract amount.
At this moment, the situation on the spot market can be anything. Let's say the dollar exchange rate was 31 rubles. However, according to the contract, the importer receives a dollar for 30 rubles.
Let the dollar exchange rate be 29 rubles in three months, but the importer is obliged to fulfill the terms of the deal and buy a dollar for 30 rubles.
Thus, the conclusion of a forward contract insured the importer against unfavorable conditions, but did not allow him to take advantage of a favorable situation.
In this example, a general pattern arises for futures contracts, namely: if they are insured against an increase in the price of the underlying asset, then they buy the contract, i.e. guarantee the purchase price for the future.
Example 3. Let in the conditions of example 2 an exporter appear instead of an importer. In three months, he should receive foreign currency earnings, which he plans to convert into rubles.
To avoid risk, the exporter hedges future sales of dollars with a forward contract. He sells a forward for dollars to the bank, that is, he enters into a contract with the bank, under which he undertakes to sell dollars to the bank at a price of 30 rubles. for a dollar.
Attention!
Three months pass, the exporter supplies dollars under the contract at a price of 30 rubles. for one dollar and receives the contract amount.
The situation on the spot market at this moment can be anything. Let's say the dollar exchange rate was 29 rubles. However, according to the contract, the exporter sells the dollar for 30 rubles.
Let the dollar exchange rate be 31 rubles in three months, but the exporter is obliged to fulfill the terms of the deal and sell the dollar for 30 rubles.
Thus, the conclusion of a forward contract insured the exporter against unfavorable conditions, but did not allow him to take advantage of a favorable situation.
In this example, a general pattern arises for futures contracts, namely: if they are insured against a fall in the price of the underlying asset, then they sell the contract, i.e. guarantee themselves a future selling price.
Despite the fact that a forward contract implies mandatory performance, counterparties are not insured against its non-fulfillment due to, for example, bankruptcy or bad faith of one of the parties to the transaction. Thus, a forward contract is characterized by credit risk.
A forward contract can be concluded for the purpose of playing on the difference in the exchange rate value of assets.
A person opening a long position expects the price of the underlying asset to rise, while a person opening a short position expects its price to decrease. Let us explain what has been said with examples.
Example 4. Game for increase. Let a speculator appear in Example 2 instead of an importer. He expects the dollar exchange rate to be 31 rubles in three months. Therefore, the speculator buys a contract with a quote of 1 dollar = 30 rubles.
If the dollar exchange rate has fallen to 29 rubles by this moment, the speculator loses 1 ruble. He is obliged to fulfill the forward contract, i.e. buy a dollar for 30 rubles, but can now sell it only for 29 rubles.
In this example, a general pattern emerges for futures contracts, namely: if they are bullish, they buy the contract, benefit from the rise in price and lose from its fall.
Example 5. Bearing game. Let the speculator in the previous example expect the dollar exchange rate to fall to 29 rubles in three months. He plays short, i.e. sells the contract for 30 rubles.
After three months, the dollar costs 29 rubles. The speculator buys it on the spot market for 29 rubles. and delivers under a forward contract for 30 rubles, winning a ruble.
Let a dollar cost 31 rubles. To fulfill the contract, the speculator is forced to buy a dollar on the spot market for 31 rubles. and deliver it under contract for 30 rubles. His loss is 1 rub.
In this example, a general pattern arises when concluding futures contracts, namely: if they play short, they sell the contract, benefit from a decrease in price and lose from its increase.
Foreign exchange forward contracts typically have standard maturity dates. Typically these are 1, 2, 3, 6, 9 and 12 months.
According to its characteristics, a forward contract is individual.
Therefore, the secondary market for forward contracts for most assets is undeveloped or poorly developed. The exception is the forward foreign exchange market.
Forward price and delivery price
When entering into a forward contract, the price at which the transaction will be executed is agreed upon. It is called the delivery price. It remains unchanged throughout the duration of the contract.
There is also the concept of the forward price of the underlying asset. This is the price of an asset for a specific time in the future, such as a three-month forward price, a six-month forward price, etc.
When the parties to the contract agree on a delivery price, they take into account market conditions relative to this point and record this price as the delivery price under the contract.
Since this price takes into account all market conditions, at this moment it is also the forward price of the asset for a certain point in time in the future.
At the next moments of time, market conditions will change, therefore, in new contracts for this asset, which expire simultaneously with our first contract, a new delivery price will arise and, accordingly, a new forward price of the underlying asset.
Attention!
Therefore, we can say that for each moment in time, the forward price of the underlying asset is the delivery price of the forward contract that was concluded at that moment.
Thus, in the market at each point in time for a certain date in the future, there is a forward price of the underlying asset and it is equal to the delivery price of forward contracts concluded at that moment.
Example. On March 1, a forward contract is concluded for the delivery of shares of company A on July 1 at a price of 100 rubles.
At the time of concluding the contract, the forward price of the share with delivery on July 1 is equal to the delivery price, i.e. 100 rubles. On April 1, another contract is concluded for the delivery of shares of company A on July 1 at a price of 120 rubles.
The new contract included a new delivery price as market conditions changed.
Thus, the forward price of the stock on April 1 (with delivery on July 1) is equal to the delivery price of the second contract, i.e. 120 rubles. In this case, the delivery price for the first contract remains equal to 100 rubles, but the forward price of the share for delivery on July 1 at this moment is 120 rubles.
Source: http://mathhelpplanet.com/static.php?p=forvardniy-kontrakt-i-cena
Future trade agreements
In a forward contract, the parties, at the time of concluding the transaction, necessarily stipulate among themselves all the necessary terms of the contract and the specific asset to be sold or purchased, its quality, the size of the contract, the contractual execution price (delivery price), the time and place of delivery. This leads to the following definition of a forward contract.
This is a materially formalized agreement between two or more subjects of foreign economic activity and their foreign counterparties, aimed at establishing, changing or terminating their mutual rights and obligations in foreign economic activity.
A forward contract or forward is an agreement between two counterparties on the terms of a transaction with an underlying instrument (asset) that will take place in the future.
Most often, such transactions take the form of buying or selling a specified quantity of a specific type of underlying instrument at a fixed price at a specified date in the future.
A forward contract has a number of advantages, namely:
- the object of trade in forward transactions, as a rule, is a product that will still be manufactured (grown) at the time of delivery, so trading participants plan their profits in advance;
- the seller (manufacturer) has the opportunity to receive an advance payment from the buyer within 50% of the contract value and use it for the production of products;
- the buyer is insured against price increases and is provided with the supply of products for their own production (resale).
Despite the fact that a forward contract provides for mandatory performance, counterparties are not insured against its non-fulfillment, for example, bankruptcy or dishonesty of one of the parties to the transaction.
Therefore, before concluding a transaction, partners should find out each other’s solvency and reputation.
Conclusion of the “Forward” agreement
The conclusion of a contract consists of at least two stages: an offer by one party to conclude a contract and acceptance of the offer by the other party.
Typically, forward contracts are used when delivering large volumes of goods.
For example, in the spring, an exporter enters into a forward contract with a commodity producer for the supply of produced grain.
In this case, the parties try to resolve the issue of pricing at the stage of concluding a contract, and payment for the goods is negotiated separately.
Exporters who take part in international tenders receive the right to supply a certain volume of goods at a certain price, which is also the essence of a forward contract.
When signing forward terms of a transaction, the parties pursue the mutual goal of mutual fulfillment of the appropriate requirements for both one and the other party to the contract.
Previously, an export contract is a written document containing an agreement between the parties on the supply of goods: the obligation of the exporter to transfer a certain product into the ownership of the buyer and the obligation of the importer to accept this product and pay the necessary amount of money for it or the obligations of the parties to fulfill the terms of the trade transaction.
The foreign economic sales contract contains an introductory part, details of the parties (legal address and bank details) and the following basic conditions:
- Subject and object of delivery (name and quantity of goods);
- Methods for determining the quality and quantity of goods;
- Delivery time and place;
- Basic delivery conditions;
- Total price – delivery cost;
- Conditions of payment;
- The procedure for delivery and acceptance of goods;
- Transport conditions;
- Conditions of guarantees and sanctions;
- Settlement of disputes;
- Circumstances of exemption from liability, force majeure.
The agreement is signed by authorized persons and their signatures are sealed.
Source: http://agrex.gov.ua/forvardnyiy-kontrakt/
What are forward transactions?
A forward transaction is a transaction between two parties, the terms of which provide for a mandatory mutual one-time transfer of rights and obligations in relation to the underlying asset with a deferred deadline for the execution of the agreement from the date of the agreement.
Such a transaction is usually formalized in writing. The subject of the agreement can be various assets - goods, shares, bonds, currency, etc.
A forward contract is usually concluded for the purpose of actual sale or purchase of the relevant asset, including to insure the supplier or buyer against possible adverse price changes.
A forward contract can also be concluded for the purpose of playing on the difference in rates of the underlying asset.
When entering into a forward contract, the parties agree on the price at which the transaction will be executed. This price is called the delivery price. It remains unchanged throughout the duration of the forward contract.
Attention!
In connection with the forward contract, the concept of forward price also arises. At each point in time, the forward price for a given underlying asset is the delivery price fixed in the forward contract that was entered into at that point in time.
When determining the forward price of an asset, it is based on the premise that the investor at the end of the period should receive the same financial result by purchasing a forward contract for the supply of an asset or the asset itself.
If this condition is violated, it becomes possible to carry out an arbitration operation. If the forward price is higher (lower) than the spot price of the asset, then the arbitrageur sells (buys) the contract and buys (sells) the asset.
Spot price is the current market price of the underlying asset. When concluding a forward transaction, the party who opened a long position hopes for a further increase in the price of the underlying asset.
When the price of the underlying asset rises, the buyer of the forward contract wins and the seller loses, and vice versa.
Gains and losses from a forward transaction are realized only after the contract expires, when cash and assets flow.
Concluding a forward contract does not require any costs from counterparties, with the exception of possible commissions associated with the execution of the transaction, if it is concluded with the help of intermediaries.
Despite the fact that a forward contract implies mandatory performance, theoretically counterparties are not insured against failure to fulfill obligations on the part of their partner due, for example, to bankruptcy or bad faith of one of the parties to the transaction.
Therefore, before concluding a deal, partners should find out each other’s solvency and integrity.
The lack of guarantees for the execution of a forward contract in the event of a corresponding situation for one of the parties is a disadvantage of a forward contract.
Another disadvantage of forward contracts is their low liquidity. Forward transactions are concluded off exchanges in unorganized markets.
All terms of the transaction - terms, price, guarantees, sanctions - are negotiated by the parties: since a forward transaction, as a rule, pursues the actual delivery of the relevant asset, the counterparties agree on conditions that are convenient for them.
Thus, the forward contract is not standard in its content.
As a result, it is believed that the secondary market for forward contracts is either very narrow or non-existent, since it is difficult to find any third party whose interests would exactly correspond to the terms of a given contract, originally concluded within the framework of the needs of the first two parties.
In fact, the degree of liquidity of the forward market directly depends on the degree of liquidity of the underlying asset.
For some underlying assets - for non-exchange goods, for unlisted corporate securities - it will be narrow and illiquid, for others, on the contrary, liquid, for example, for currency, government securities.
If the underlying asset is liquid, the arrangement formalized by the forward contract may also be liquid. To this end, the parties provide for the possibility of transferring the contract to third parties during the term of the agreement.
Thus, we can talk about the purchase and sale of forward contracts, which is still based on the purchase and sale of the underlying asset.
If a forward contract is sold on the secondary market, it acquires some value because there is a difference between the delivery price and the current forward price.
The shape of the forward curve—the dependence of the prices of futures contracts on their term—significantly influences the behavior of spot market participants.
When the prices of contracts with a further expiration date are higher than the prices of nearby contracts, the market is in a state of contango.
The shape of the price curve in this case allows us to draw a conclusion about the expected increase in prices for the underlying asset in the future, and the profitability of the strategy of buying and holding goods stimulates buyers and leads to an increase in inventories, while the value of the intertemporal spread should be comparable to the cost of storing the goods.
If the prices of distant contracts are lower than the prices of nearby ones, i.e. the forward price curve is inverted, the market is in a state of backwardation.
This shape of the curve leads to the fact that the accumulation of inventories becomes unprofitable for companies, which leads to their reduction.
At any given moment, the market absorbs all available information and sets spot and forward rates. At this point, the forward rate forecasts the value of the spot rate in the future.
However, during this time various economic and political events and even disasters are possible. All this changes market forecasts and is reflected in prices.
It is not surprising that these rates ultimately turn out to be different, and their difference does not contradict the fact that forward rates coincide with the predicted values of future spot rates.
In order for the forecast to be correct, the participant must correctly predict today the unexpected events that will occur before the forward transaction is executed.
Rollover transactions “report” (repo) and “deport” (reverse repo) are a type of short-term forward contract.
A repo is an agreement between counterparties under which one party sells securities to the other with an obligation to buy them back from it after some time at a higher price.
As a result of the transaction, the first party actually receives a loan secured by securities.
The interest on the loan is the difference in prices at which it sells and buys back the securities. Her income is the difference between the prices at which she first buys and then sells securities.
A repo transaction is an over-the-counter forward transaction. One party to the transaction is, for example, a speculator who entered into a transaction for a period in order to obtain exchange rate differences.
The need for a rollover transaction arises in him if the change in the exchange rate he predicted did not take place and liquidation of the transaction will not bring profit.
However, the professional who concluded the deal expects that his forecast for the change in exchange rate will come true in the near future, so it is necessary to extend the terms of the deal, i.e. prolong it.
Thus, the extension transaction is concluded by him with the aim of receiving profit at the end of its term from his speculations under the transaction agreement concluded earlier. Much less common on the market is deport - an operation reverse to report.
This trade is used by a “bear” - a professional short seller - when the price of a security has not decreased or has decreased slightly and he expects a further decrease in the rate.
Deportation is also applied in cases where it is necessary to deliver securities to one’s counterparty, but the broker or dealer does not have these securities in stock. Then he resorts to deportation to fulfill his obligations.
A reverse repo is an agreement to purchase securities with an obligation to sell them at a later date at a lower price.
In this transaction, the person who buys the securities at a higher price is actually borrowing them against the security of the money.
The second person providing a loan in the form of securities receives income (interest on the loan) in the amount of the difference in the prices of sale and repurchase of securities.
Source: http://cic.ru/?page=3
Why FCs are the basis of all derivatives
The most complex type of investment product falls under the broad category of derivative securities, or derivatives. Most investors find it difficult to understand the concept of a derivative.
However, derivatives are used by government and banking institutions, asset management companies and other corporations to manage investment risks.
Therefore, it is important for investors to have a general understanding of this type of product and how professional investors use it.
Forward Derivative Contract Overview
As a type of derivative product, forward contracts are a good example that provides an overview of more complex derivative instruments such as futures, options and swap contracts.
Forward contracts are very popular because they are not regulated by the government, guarantee privacy to the seller and buyer, and can be modified to suit the requirements of both.
Attention!
Unfortunately, due to the opacity of forward contracts, the size of the forward market is essentially unknown. In turn, this makes the forward market less clear to investors than other derivatives markets.
Since forward contracts lack transparency at all, a number of issues may arise when using them. For example, parties to a forward contract are exposed to credit, or default, risk.
Completing a trade can be challenging due to the lack of a formal clearing house. It is also likely that large losses will occur if the derivative contract is not structured correctly.
As a result, in forward markets there may be serious difficulties in moving funds from participants in these types of transactions to society as a whole.
Today, problems such as systematic failure to fulfill obligations by the parties to a forward contract have still not been resolved.
However, the economic principle of “too big to fail” will always sound tempting as long as large institutions are allowed to guarantee forward contracts.
The problem becomes even greater when we consider the options and swaps markets.
Trading and settlement procedures
Forward contracts are traded in the over-the-counter market. They are not traded on exchanges such as the NYSE (New York Stock Exchange), NYMEX (New York Mercantile Exchange), CME (Chicago Mercantile Exchange) and CBOE (Chicago Board Options Exchange).
When a forward contract expires, the trade can be settled in one of 2 ways.
The first of these is carried out by “delivery”. This type of arrangement implies that the party holding the long forward contract will pay the holder of the short position on the contract when the asset is delivered and the transaction is completed.
While the concept of “delivery” is easy to understand, actually taking delivery of the underlying asset can be very challenging for the short position owner.
Therefore, forward contracts can also be settled by another method known as cash settlement.
This type of settlement is more complex than “delivery”, but nevertheless it is quite logical.
For example, suppose that at the beginning of the year, a grain company entered into a forward contract with a farmer to purchase 1 million bushels of grain (1 bushel in the United States is approximately 35.2 liters) on November 30 of that year at a price of $5 per bushel.
Let's say that by the end of November the price of grain on the open market reached $4 per bushel. Thus, the company that is long the forward contract must receive from the farmer an asset that is now worth $4 per bushel.
However, since the parties agreed to pay $5 per bushel at the beginning of the year, the company can simply ask the farmer to sell the grain on the open market for $4 per bushel and then make a cash payment to the farmer at $1 per bushel.
Then the farmer will receive the same $5 per bushel of grain. On the other side of the deal, the company will then simply purchase the required number of bushels of grain on the open market at a price of $4 per bushel.
As a result, the company will settle with the farmer in the form of 1 dollar for each bushel of grain. In this case, cash payment was used to simplify the delivery process.
Overview of currency FC
The terms of use of derivative contracts can turn them into complex financial instruments. A foreign exchange forward contract provides a good example.
However, before understanding the nature of a foreign exchange forward transaction, it is important to understand how currencies are quoted to the public and how they are used by institutional investors.
This type of conversion is very popular and is known as indirect quotation. Most investors probably think of currency exchange this way.
However, institutional investors use the direct quote method when conducting financial analysis. Here the amount of national currency per unit of foreign currency is determined.
This method was developed by securities industry analysts because institutional investors think in terms of the volume of national currency per unit of a particular share, rather than calculating how much of the stock can be bought per unit of national currency.
Attention!
Given this distinction, it is the forward quote that will be used to explain how a forward contract can be used to implement a covered interest rate arbitrage strategy.
Let's assume that an American currency trader works for a company that regularly sells its goods in Europe for euros, after which they need to be converted back into US dollars.
In this case, the trader will likely know the spot and forward rates between the US dollar and the euro on the open market, as well as the risk-free rate of return for both currencies.
For example, a currency trader knows that the US dollar/euro spot rate on the open market is $1.35 per euro, the US annualized risk-free rate is 1%, and the European risk-free interest rate is 4%.
The one-year foreign exchange forward contract is quoted at $1.50 per euro on the open market.
With this information in hand, the currency trader is able to determine whether covered interest rate arbitrage is possible and how to enter a position to generate a risk-free return for the company using a forward contract.
Example of a covered interest arbitrage strategy
Before turning to a covered interest rate arbitrage strategy, a foreign exchange trader first needs to determine what the dollar-euro forward contract should be in an effective interest rate environment.
To do this, you need to carry out the following calculations: the spot rate of US dollar per euro is divided by the sum of one unit and the annual risk-free rate in the EU, and then multiplied by the sum of one and the annual risk-free rate in the US.
x (1 + 0.01) = 1.311
In this case, a one-year forward contract between the dollar and the euro should sell for $1.311 per euro. Since a similar one-year forward contract sells for $1.50 per euro on the open market, the currency trader knows that the forward contract is overpriced on the open market.
Since anything that is overpriced will subsequently be sold for a profit, a savvy foreign exchange trader will sell the forward contract and purchase euros on the spot market to earn the risk-free rate of return on the investment.
You can carry out a covered interest arbitrage operation in the following way:
Step 1: The currency trader needs to have 1.298 dollars and purchase 0.962 euros with it.
To determine the amount of US dollars and euros needed to implement a covered interest arbitrage strategy, you need to divide the spot price of the contract ($1.35 per euro) by the sum of the unit and the annual EU risk-free rate (4%):
1,35 / (1 + 0,04) = 1,298
In this case, $1,298 is required to facilitate the transaction. The trader then determines how many euros are needed to facilitate the transaction.
To do this, the unit is divided by the sum of the unit and the European annual risk-free rate (4%). The result is 0.962 euros.
1 / (1 + 0,04) = 0,962
Step 2: The trader needs to sell the forward contract to receive 1.0 EUR at the end of the year at a price of 1.50 USD.
Step 3: You must hold the euro position for a year, thereby the trader earns interest in the amount of the European risk-free rate (4%).
This euro position will increase in value from 0.962 euros to 1.00 euros.
0.962 x (1 + 0.04) = 1.000
Step 4: Finally, at the expiration of the forward contract, the trader will bet 1.00 EUR and receive 1.50 USD.
The described transaction will be equivalent to a risk-free rate of return of 15.6%. You can determine it by dividing $1.50 by $1.298 and then subtracting one from the resulting amount.
(1,50 / 1,298) – 1 = 0,156
It is very important that investors understand the mechanics of a covered interest arbitrage strategy.
This is a good illustration of why interest rate parity must always be satisfied to prevent unlimited risk-free returns.
Relationship with other derivatives
Forward contracts can be structured in such a way that they become very complex financial instruments.
The variety of forward contracts increases exponentially when you consider how many different types of underlying financial instruments can be used in forward contracts.
Attention!
Examples include securities forward contracts based on portfolios of individual securities or indexes, fixed income forward contracts based on securities (such as Treasury bills), and interest rate forward contracts (such as LIBOR), more commonly known as agreements on future interest rates.
It is also important for investors to understand that forward derivative contracts are generally considered to be the underlying basis for futures, options and swap contracts.
The reason is that futures contracts are basically standardized forward contracts with a formal exchange and clearinghouse.
Options contracts are essentially forward contracts that give the investor the right, but not the obligation, to complete a transaction at a specific point in time in the future.
Swap contracts are agreements in the form of a chain of forward contracts that require certain periodic actions from the investor.
Once the relationship between forward contracts and other derivatives is clear, investors can quickly understand the variety of financial instruments available and understand the risk management implications of using derivatives.
It also becomes clear how important the derivatives market is to government and banking institutions, as well as large corporations around the world.
Forward transaction(Forward Operation, FWD) - a forward transaction for exchanging currencies according to a pre-agreed agreement, which is concluded today, but the value date (execution of the contract) is postponed for a certain period in the future.
The market for foreign exchange forward transactions has been an integral part of the global market since the early 1980s. For the first time, forward transactions began to be used by London banks in interbank transactions with Eurocurrencies. In August 1985, the British Bankers' Association (BBA) issued rules governing transactions in the interbank foreign exchange market (FRABBA terms), which still guide banks when concluding forward transactions.
The basis of a forward transaction is an agreement for the purchase and sale of foreign currency during a certain period or at a certain date in the future at the rate agreed upon on the date of the transaction. Forward transactions are futures contracts on the interbank foreign exchange market. The terms of forward transactions are standardized and, as a rule, do not exceed 12 months. The most common are forward transactions for 1, 2, 3, 6, 9 and 12 months. In practice, these periods are reflected as 1M, 2M, 3M, etc.
Recently, forward transactions have been widely used for non-trading transactions related to the movement of capital: lending to foreign branches, investing, purchasing securities of foreign issuers, repatriating profits, etc.
A forward transaction is binding and is concluded primarily for the purpose of actually buying or selling currency. The most common use of such transactions is to hedge unsecured exposures, however they can often be used for speculative purposes.
The terms of forward transactions are as follows:
- the exchange rate is fixed at the time of concluding a forward transaction;
- the actual transfer of currency takes place after a certain agreed standard period of time;
- when signing the agreement, no preliminary payments are made;
- contract volumes are not standardized.
The financial content of a forward transaction is the purchase or sale of one currency in exchange for another, based on the interests of the buyer (seller), in order to make a profit or prevent losses.
The specificity of a forward transaction is that forward exchange rates, unlike other types of transactions, are not directly fixed, but are calculated. and professional ones operate with indicators expressed as ten-thousandths of the exchange rate, reflecting the difference between the spot rate and the forward rate. These indicators are called forward margin (, points, pips) and in practice, quotes are made not for rates, but for the corresponding differences.
The forward exchange rate is calculated at the time of concluding a forward transaction and consists of the current rate (spot rate) and forward margin, which can be in the form of a discount (). If the forward exchange rate is higher than the current one, a forward premium is added to the spot rate to determine it. If the forward rate is lower than the current one, it is determined by subtracting the forward discount (discount) from the spot rate.
In practice, in order to distinguish between a premium and a discount, they are often written with a “plus” or “minus” sign, respectively, but the dealer will always accurately determine the premium or discount even if the sign is not indicated. This is explained by the fact that the buyer's rate is always lower than the seller's rate. Therefore, if the forward margin (spread) indicators are given in increasing order, for example 150 - 200 or [(-100) - (-20)], then we are talking about a forward premium. If the spread is given in descending order, for example 220 - 100 or [(-50) - (-180)], then the dealer takes this spread into account as a forward discount (discount).
Forward rates differ from spot rates by a significantly larger absolute value of the indicator (the difference between the selling rate and the buying rate). This is due to the specifics of a forward transaction, which is also a form of insurance for currency risks. The longer the forward period, the higher the level will be, and therefore, the larger the forward margin will be.
The main factor that shapes the dynamics and level of the forward exchange rate is the difference in interest rates on interbank loans and deposits in the respective currencies. The general rule for the dynamics of the forward exchange rate is that the forward rate exceeds the spot rate to the extent that bank deposit rates for the currency being quoted are lower than for counterparty currencies.
A currency with a higher interest rate in the forward market will sell at a discount to a currency with a low interest rate, and a currency with a lower interest rate will sell at a premium to a currency with a high interest rate.
Thus, the forward rate differs from the current rate by the amount of the forward margin (premium or discount). In professional terminology, the term “outright” rate is used to define the forward rate. This means that the buyer wants to buy a certain amount of currency in the future (or the seller wants to sell) without conducting additional transactions or concluding additional agreements. This term is used to avoid confusion in understanding the terms of a forward transaction when we are talking about one simple forward transaction, as opposed to a complex combination associated with the simultaneous implementation of forward and current transactions (swap transactions).
In practice, information on forward rates of major currencies is regularly published in financial publications.
Recently, new forms and modifications of classic forward transactions have appeared, in particular:
- extension of the forward transaction period;
- use of forward options with an open expiration date;
- use of forward options and cross-dated ones;
- use of currency accounts;
- concluding indirect forward transactions;
- ensuring foreign exchange coverage;
- independent creation of a “forward”;
- use of forward contracts with a cancellation option (FOX);
- use of forward interest rate agreements, etc.
A forward contract is a contract with the help of which a forward currency transaction is concluded. Under this transaction, one party (the seller) undertakes to sell to the other (the buyer) a certain amount of foreign currency at a certain point in the future at a price fixed at the time of this transaction (Fig. 18.1). The day on which the transaction will be settled is called the value date, and the price fixed in the forward contract is called the delivery price.
Forward transactions are usually concluded on the over-the-counter market. In this case, the parties agree among themselves on all the essential terms of the transaction: the amount of the base currency, the time and method of its delivery, the delivery price. Such conditions for concluding a forward contract make it unique, which significantly reduces its further liquidity. When concluding a contract, the parties do not bear any financial costs, except in cases where the transaction is concluded with the help of intermediaries.
Conclusion
Forward Delivery
currency contract
Delivery of rubles
a) Transaction date b) Value date
When concluding a forward transaction, its parties open their currency positions: the seller - short, the buyer - long. You can close a position by entering into a counter-trade.
In most cases, forward contracts are entered into to insure against currency risk associated with an unfavorable change in the exchange rate of the underlying currency in the future. In this case, the seller, who according to the contract is, as a rule, the owner of the base currency, is insured against a fall in its exchange rate, and the buyer, who is interested in receiving real currency, is insured against its rise. However, a forward contract can also be used for speculative purposes when the goal is to play on changes in exchange rates over time. In this case, it is more appropriate to enter into settlement forward contracts.
Settlement forwards. A settlement forward contract is a contract with the help of which a conversion transaction is executed, which is a combination of two transactions: a transaction under a foreign exchange forward contract and the fulfillment of obligations to conduct a counter transaction at the current exchange rate on the date of its value. In practice, this is a forward contract under which there is no delivery of the base currency, i.e. the seller sells, and the buyer buys this currency conditionally. How are payments made under this contract?
As stated above, a settlement forward contract is entered into if the parties involved have purely speculative purposes. Consequently, they are only interested in making a profit, which the loser transfers
winning side. The winning and losing parties are determined by the following rule: if the current exchange rate of the base currency on the day of execution of the settlement forward contract exceeds the delivery price of this currency under the contract, then the difference between these rates, multiplied by the contract amount, is paid by the seller of the contract, and vice versa. This rule is based on the following reasoning: if the forward contract were staged, then in order to deliver the currency under it, the seller would have to buy it at the current rate, and if this rate were higher than the delivery price under the contract, then he would would have suffered losses. The buyer in this case, having received the currency at the delivery price, could sell it at the current rate and thereby make a profit.
Therefore, when concluding a settlement forward foreign exchange contract, the seller expects a decrease in the exchange rate of the base currency, and the buyer expects its increase.
This type of conversion operations was widely developed in Russia until August 1995, when, due to the introduction of a currency corridor, the volatility (fluctuation) of the exchange rate that had been observed before was sharply reduced. At that time, the US dollar was most often used as the base currency, and its current exchange rate was the rate established during trading on the MICEX. The active use of settlement forwards was caused by two reasons:
speculative prevailing in the market;
legislative restrictions (for banks - the lack of a foreign exchange license), due to which many did not have the right to enter into supplyable foreign exchange forward contracts.
Currently, when concluding a settlement foreign exchange forward, either the exchange rate fixed at trading in SELT or the official exchange rate established by the Central Bank of the Russian Federation can be used as the current rate.
Let us consider the procedure for carrying out transactions on settlement currency forwards using the following conditional example: on September 10, 1999, Bank A and Bank B enter into a settlement forward contract, according to which Bank A undertakes on December 1, 1999 to conditionally sell to Bank B 100,000 US dollars at exchange rate of 26.25 rubles/dollars. Settlements between banks under this contract are made according to the above-described rule. As
Based on the current exchange rate, the official US dollar exchange rate established by the Central Bank of the Russian Federation is used.
Let us consider the procedure for carrying out transactions on settlement currency forwards using the following conditional example: on September 10, 1999, Bank A and Bank B enter into a settlement forward contract with each other, according to which Bank A undertakes on December 1, 1999 to conditionally sell to Bank B 100,000 US dollars at exchange rate 26.25 rub./dollar. Settlements between banks under this contract are made according to the rule described above. The current exchange rate is the official US dollar exchange rate set by the Central Bank of the Russian Federation.
On December 1, 1999, the Central Bank of the Russian Federation sets the official exchange rate of the US dollar at 26.53 rubles. dollars. Since the current exchange rate is higher than the delivery price under the contract, the losing party is Bank A. It transfers funds to Bank B in the amount of 26.53 - 26.25 rubles. $100,000 = 28,000 rubles, which is the latter’s profit under this contract.
Currency futures. A futures contract is an exchange contract, according to which one party (the seller) undertakes to sell to the other (the buyer) a certain amount of foreign currency at a certain point in the future at a price fixed at the time of concluding this contract. From the definition it is clear that futures and forward contracts are very similar to each other. However, a futures contract has a number of differences due to the fact that a futures contract is a forward currency transaction concluded on an exchange.
The first difference is that when concluding a futures contract, it is not necessary to agree on all its terms: the quantity, timing and method of delivery of the base currency are standard and determined by the exchange specifications. In this regard, futures contracts have high liquidity and there is an active secondary market on the issuing exchange. Thanks to this, banks can quite easily close their positions in futures contracts by making a counter-trade with the same number of contracts for which the position was open. Therefore, futures contracts are most often concluded for speculative purposes and, as world practice shows, only 2-5% of futures contracts end in the actual delivery of currency.
Since the terms of a futures contract are standard, participants in a futures transaction trade only for the price at which it will be concluded, as well as for the number of contracts that will be concluded.
The second difference is that under a futures contract there is virtually no risk of non-execution of the transaction by the counterparty, which is so great when concluding any over-the-counter contract, including forward ones. This is achieved thanks to the guarantee of its execution by the exchange, which often itself acts as the opposite party to each transaction concluded.
Another difference is that when entering into a futures contract, its participants incur expenses in the form of a commission, which they pay to members of the exchange, if they themselves are not such.
To open a position in a futures contract, you must deposit a certain amount of cash or securities, called initial margin. These funds provide certain protection to the exchange, which guarantees its execution.
Another way to protect the exchange from losses in the event of clients’ failure to fulfill the contracts they have concluded is the daily revaluation of their open positions, which
which is carried out according to the same rule as when executing a settlement forward. Only the current rate is used for the settlement price, which is determined on the basis of supply prices for each type of futures contracts concluded. At the end of each trading day, the exchange clearinghouse transfers the winnings from the accounts of the losers to the accounts of the winning bidders. These amounts are called variation margin. Thus, participants in futures trading are aware of their profits or losses on futures contracts on a daily basis. They can withdraw the profits made or must cover the losses incurred.
If positions on currency futures contracts remain open until the date of their execution, then settlements on them are made in the manner established by the exchange.
In a simplified form, the procedure for carrying out transactions on currency futures can be presented in the following form (see Fig. 18.3).
(the underlying asset) at a specified time in the future, at a predetermined price. Such a document is concluded for the purchase (sale) of a certain amount of a material or financial asset.
Each party undertakes to fulfill the obligations agreed upon in writing: one to make the delivery, the other to accept it. Initially, a price for the execution of the transaction is agreed upon that suits all parties. It is called the delivery price and remains unchanged throughout
The person who commits to deliver the asset takes a short position (that is, sells the contract). The second party to the transaction, purchasing the asset, in turn opens a long position (that is, buys a contract). Completing a transaction does not require any expenses from counterparties, except for commissions when concluding it with the help of intermediaries.
A forward contract is signed with the purpose of making an actual purchase (sale) of various types of assets and insuring the buyer (as well as the supplier) against a possible change in price unfavorable for any participant. Such a contract implies mandatory fulfillment. In some cases, however, there are risks, for example, in the event of bankruptcy of one of the participants. Therefore, in order to protect yourself, before concluding such a transaction, it is necessary to find out the reputation and make sure of the solvency of the future counterparty.
Sometimes a forward contract is entered into to make a profit from the value of an asset. This is done in case of expectation of an increase or decrease in the prices of the underlying product.
Such a contract is individual, therefore, as a rule, it is not used on the secondary market. The exception is the forward foreign exchange market.
The result is considered to be the actual delivery of goods. The subject of a forward transaction is a commodity available. Such a contract is fulfilled strictly within the period established by the contract.
The forward is an excellent means of insuring profits. The concluded transaction fixes the conditions existing at the time of signing the documents: price, execution time, quantity of goods, etc. Such insurance of the parties against changes in the original terms of the transaction is called hedging.
As a rule, the cost of goods under such transactions does not coincide with the prices under cash transactions. It represents the average exchange price of a particular product. The forward value is determined by the parties to the transaction based on the assessment of all factors and prospects that affect the state of the market.
The peculiarities of the financial market have led to the fact that the forward contract began to be divided into settlement transactions (non-deliverable) and delivery transactions. The latter involve the implementation of deliveries and mutual settlement by transferring the difference formed in the price of a given product, or the amount previously agreed upon under the contract.
Under a forward contract, shares are assumed or non-payment is stipulated. When they are paid during the term of the transaction, its price is adjusted by the amount of the transferred dividends, based on the fact that subsequently (after purchasing the contract) the investor will no longer receive them.
Thus, a forward is a fixed-term contract, a firm deal that is binding. This contract cannot be called standard. Since it is very narrow, it is very difficult to find a third party whose interests would fully comply with the terms of the contract. Therefore, the deal is concluded within the framework of the needs of only two parties. A party can liquidate a position under a contract only with the consent of the counterparty.
