Forwards and Futures

Table of Contents

Table of Contents......................................................................................................................................................1
1. Spot Transaction and Forward Transaction .........................................................................................................1
2. Forward Contract..................................................................................................................................................1
2.0 Introduction......................................................................................................................................................1
2.1 Definition.........................................................................................................................................................1
2.2 Characteristics of a forward contract...............................................................................................................1
2.3 Forward foreign exchange contract ................................................................................................................2
2.4 Forward foreign exchange Option contract .....................................................................................................3
3.0 Introduction......................................................................................................................................................3
3.1 Definition.........................................................................................................................................................3
3.2 Characteristics of Futures Contract.................................................................................................................3
3.3 Types of Futures Contract...............................................................................................................................3
4. Differences between Forward and Futures Contract.............................................................................................3

1. Spot Transaction and Forward Transaction

Every trade has two distinct dates associated with it, a trade date and a settlement date.
A Trade date is the day when an agreement was made between two parties where as a settlement date where the actual cash flow occurs.
When the settlement happens after two business days it is termed as a Spot Transaction however, the settlement date is beyond the spot
date. Such a transaction is a forward transaction and is called a Forward outright.

2. Forward Contract

2.0 Introduction

A forward contract is an agreement between two parties to buy or sell an asset at an agreed price on an agreed date. Hence it is an
obligation for both the parties to fulfill the terms of the agreement at the specified date.

2.1 Definition

“A Forward Transaction is a contractual obligation between two parties where in the transaction takes place today (i.e. Trade Date) and
final settlements takes place at a future date where the terms and exchange rate (in case of a forex) is fixed today.”

Example 2.1.0:

A wants to buy a house after 6 months and B wants to sell his house after the same period ,hence they enter in to a forward agreement
where in B will sell the house to A after 6 months at an agreed price. Now lets say the price of the house as of today is Rs. 100/- and will
rise in future. Hence B has a Risk that if he sells the house today at Rs. 100/- and the price of the house after 6 months is Rs. 104/- he will
have a loss of Rs. 4/- hence he will quote a higher price to A then the current price.

2.2 Characteristics of a forward contract

 It is an agreement between two parties
 It involves two dates (a trade date and a settlement date) and
 It has an agreed price to be paid or received.
 It is a contractual obligation for the parties signing the agreement.

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2.3 Forward foreign exchange contract

When the underlying assets in case of a Forward Contract are two currencies then we call it as a Forward Foreign Exchange Contract. In a
Forward Foreign Exchange Contract two parties agree to buy or sell one currency against the other at an agreed exchange rate on a pre
determined future date. The Forward Exchange rate is calculated for the two currencies based on the following formula:

Ft = S * (1+IR2) / (1+IR1)

Where,

Ft = Forward Exchange Rate Country 1 vs. Country 2 for time t

S = Spot Exchange Rate Country 1 vs. Country 2
IR1 =Interest rate of Country 1’s Currency
IR2 = Interest rate of Country 2’s Currency

The concept can be understood through the example illustrated below:

Example 2.3.0:

An importer in India who is importing goods from Japan expects his shipment to reach India after 3 months and therefore needs to make
payment of 100K YEN to a Japanese company after three months. He therefore enter in to a forward contract with ICICI Bank to receive
100K YEN after 3 months at a following rate- 1 INR =1.9491 YEN
Trade Date: 01/01/2009
Settlement Date:

Spot Yen per Rupee- 1 INR =1.9491 YEN

Indian Rupee Interest Rate (3 Months) - 0.060000
Japanese Yen Interest Rate (3 Months) - 0.036150

F 0.5 = 1.9491 x (1 + 0.036150)

(1 + 0.060000)
F 0.5 = 1.9052

Hence the Forward Exchange Rate after 6 months is INR|YEN is 1.9052

In the foreign exchange market the difference between the spot rate and the forward rate is called a Premium if it is positive and Discount if
it is Negative. In our example the premium is 0.0439.

Example 2.3.1:
Given the following spot FX spot and money market rates, what should be the theoretical 90 day forward FX rate?

Spot rate = 1.3500 CAD/USD

Canadian 90-day Libor = 4.50%

US 90-day Libor = 3.80%

F0.5 = 1.35 X (1 + ((90/365) * 0.045)) = 1.3521

(1 + ((90/360) * 0.038))

Argument Description Sample Data Switch

FX_spot spot price of underlying currency (domestic per 1 unit of foreign) 1.35

Domestic rate (for term of forward) = 0.045

Foreign rate (for term of forward) = 0.038

Settlement date = 23-Sep-03

Future delivery date = 22-Dec-03

Accrual method for domestic rate 1= actual / 365

Accrual method for foreign rate 2 = actual / 360

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2.4 Forward foreign exchange Option contract

Forward foreign exchange Option contract is similar to a Forward foreign exchange contract except that in this case the settlement may
happen any time in between two agreed date. Hence in the above example if the importer is not sure when exactly he will receive his
shipment however, he is sure that the shipment will reach him between 1/06/2009 to 20/06/2009 he can go for a Forward foreign exchange
Option contract.

In such cases the importer can enter into a Forward foreign exchange Option contract where he has an option to settle the transaction
between two specified dates.(here 1/06/2009 to 20/06/2009) however he has an obligation that he has to settle the transaction in between
the two mentioned dates. Such a contract is called a Forward foreign exchange Option contract.

3. Futures Contract

3.0 Introduction

Futures or futures contracts are derivatives bought or sold on a futures exchange. They are contracts to buy or sell a particular commodity
at a specified price on a certain date in the future. The underlying asset could be commodities, energy, currencies, government bonds or
other financial instruments. The future date on which the contract is executed is known as the final settlement date or the delivery date. The
predetermined price is known as the settlement price.

3.1 Definition

“A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock
index, at a specified price, on a specified future date.”

3.2 Characteristics of Futures Contract

Following are some of the Characteristics of a Futures Contract
 Futures are exchange-traded derivatives.
 Futures are highly standardized. This standardization is ensured by specifying
a. The underlying asset – The particular asset as well as the quantity are specified in the futures contract.
b. The currency - The currency in which the contract is to be executed is also specified.
c. Settlement - The delivery month and the last trading date are also mentioned in the contract.
 Futures are used for hedging, particularly in a bear market. Those who have an interest in the underlying asset can protect themselves
from the risk of price changes via futures contracts.
 Futures have lower transaction costs than other debt instruments.
 They also have high liquidity, since buyers and sellers of futures contracts can be found easily.
 Most future contracts are actively traded and are closed out by offsetting before the settlement date

3.3 Types of Futures Contract

Almost any commodity can have a futures contract defined for it.
Typical commodities include

a. Food products (e.g. cocoa, sugar, corn, soybeans, orange juice, coffee),
b. Precious metals (e.g. gold, silver, platinum, etc),
c. Currencies (e.g. Swiss francs, Deutschmarks, Yen, etc),
d. Stock indexes (e.g. SP500)
e. Financial products (e.g. treasury bonds - to hedge against interest rate fluctuations)

4. Differences between Forward and Futures Contract

1. Futures trade on organized exchanges whereas forwards are traded OTC.

2. Futures contracts have standardized contract terms whereas the terms of forward contracts are individually negotiated.
3. Futures exchanges have clearinghouse arrangements to guarantee the fulfillment of contract obligations; the fulfillment of contract
terms in the forward market depends on the creditworthiness of the contract’s counterparties.
4. Futures contracts generally require margin payments and daily settlement whereas forward contracts do not.
5. Futures positions can be closed easily. Forward contracts cannot.
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6. Futures markets are regulated by identifiable government agencies, while forward markets are self-regulating in accordance with
contract law.