Forward Contracts

Below is all about forward contracts and how forward contracts work. First let's discuss what a forward contract is. The forward contract is settled at maturity. Forward contracts are frequently entered on foreign exchange.

Definition of forward contract

A forward contract is the agreement to buy or sell at a future time at a certain price.

Forward contract discussed

How a forward contract actually works is that:

• one party assumes a LONG position and agrees to buy...
• one party assumes a SHORT position and agrees to sell...

What is the price set for a forward contract?

The price is called the delivery price.

At the time a forward contract is entered into, the delivery price is chosen such that the value of the forward contract to both parties is zero. Then the price moves according to the market. The key variable that determines the price of the forward contract is the market price of the asset.

Definition of forward price

The Forward Price is sometimes defined as the delivery price which would make the contract have zero value.

How do forward contracts work?

Initially the price of the forward contract, often denoted by F, is zero. Then as the asset price rises:

• the value of the long position becomes positive, and
• the value of the short position becomes negative

What is the payoff of the forward contract?

The payoff of a forward contract for:

• long position = spot price - delivery price
• short position = delivery price - spot price

Since it costs nothing to enter into a forward contract, the payoff is the investor's total gain or loss from the forward contract.