Forwards

A forward is exactly the same as a future except that it is Over The Counter and not Exchange Traded


Assuming interest rates are known in advance, forward prices and futures prices of the same maturity must be indentical.




Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies or commodities.


Holding is the same as Position


Forward prices are quoted in the FT
SS


Opportunity Cost

The simplest type of forward contract is the one where the only cost of carry is the opportunity that the buyer has to invest the money before the delivery date.
If it is a one year forward contract the exchange of cash and asset will take place in 1 years time.
The delivery price is agreed today but the payment will take place in 1 years time.
Because the exchange only happens in 1 years time the buyer can invest the money elsewhere for a year until it is needed.
This opportunity to invest from now until the delivery date is known as the opportunity cost
This opportunity cost is the interest that can be earned on investing the spot price for this period of time
This opportunity cost is the future value of the spot price.


In emerging markets non deliverable forwards are used to hedge currencies that are not freely tradable.


Facts about a Forward

  • Forwards are traded Over The Counter.

  • Forwards are more bespoke to the exact needs of the client.

  • Forward contracts typically go to delivery.

  • There is no secondary market for forwards since they are generally bespoke by nature.

  • No money changes hands until the maturity date.

  • Forwards are commonly used in conjunction with exchange rate exposure.



Facts about a Future

  • Futures are traded on exchanges.

  • Futures have standard contract terms (sizes and maturity dates).

  • Most future contracts are sold out of before delivery by the trader taking an opposite position in the same maturity.

  • There is a large secondary market for futures.

  • Future contracts are settled at the end of the every day using margin accounts. There is a gradual payment of funds from initiation to maturity. Because you settle the change in value on a dialy basis, the value of the futures contract at any time during its life is zero.

  • Futures are commonly used in conjunction with commodities.



Important

It is important to remember that the forward price has nothing to do with where the markets thinks the price of the underlying asset will be at maturity.
When you are pricing forrward contracts the markets expectation about the value of the asset at maturity is irrelevant.


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