FORWARD CONTRACT

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Forward contract is traded over-the-counter market usually between two financial institutions or between a financial institution and one of its clients. One of the parties agrees to buy the underlying asset on the certain specified future date for a certain specified price that is it takes the long position. The other party takes agrees to sell the asset on the same date for the same price that is it takes the short position. The most popular are the forwards on foreign exchange.

Consider an example

Table provides the quotes on the exchange rate between the British Pound (GBP) and US Dollars (USD) that might have been provided by the large multinational bank on August 16, 2001. The quote for the number of the USD per GBP the first quote indicates that the bank is prepared to buy the sterling in the spot market at $1.442 and sell sterling in the spot market for $1.4456. The quotes indicate the future price at which the bank is willing to sell and buy the USD.

PAY-OFFs from Forward Contracts
Suppose the trader with the large corporation knows that the corporation will pay £ 1 million in 6 months and wants to hedge against the rate fluctuations. Using the quote the trader agrees to buy £ 1 million for $1,435,900. If the exchange rate rose to, say, 1.5000, at the end of six months the forward contract would be worth $64,100 (=$1,5000,000 - $1,435,000) to the corporation. It would enable £ 1 million to be purchased at 1.4359 rather than 1.5000. Similarly, if the spot rate fell to $1.4000 at the end of six months, the forward contract would have a negative value to the corporation of $35,900 because it will the corporation paying $35,900 more than the market price of the sterling.
In general, the payoff from the long position in a forward contract on one unit of an asset
                                                ST -K
Where K is the delivery price of the asset and ST is the spot price of the asset at maturity of the contract.

Similarly the payoffs for a short positions in a forward contract on one unit of an asset is
                                                K - ST

The payoffs can be negative or positive. As it costs nothing to enter into the forward contract the payoff from the contract is also the trader’s total gain or loss from the contract.