Introduction to Corporate Finance

ONLINE CHAPTER

risks associated with those strategies. Customised hedging strategies, especially those that are financially

engineered, are effective and accurate, but suffer from greater transaction costs and low liquidity. Off-

the-shelf solutions, such as exchange-traded derivative securities, while attractive because of their low

transactions costs, high liquidity and low default risk, may not effectively and accurately offset the risk

exposure.

CONCEPT REVIEW QUESTIONS 23-1

1 What does it mean to say that a company, by not hedging, is speculating on changes in the risk

factor?

2 Why do you think derivative securities have acquired a questionable reputation?

23-2 FORWARD CONTRACTS

As discussed in Chapter 17, a forward contract involves two parties agreeing today on a price, called the

forward price, at which the purchaser will buy a specified amount of an asset from the seller at a fixed

date in the future. This is in contrast to a cash market transaction, in which the buyer and seller conduct

their transaction today at the spot price. The buyer of a forward contract has a long position and has an

obligation to pay the forward price for the asset. The seller of a forward contract has a short position

and has an obligation to sell the asset to the buyer in exchange for the forward price. The future date

on which the buyer pays the seller (and the seller delivers the asset to the buyer) is referred to as the

settlement date. It is important to note that, unlike options, which were discussed in Chapter 8, forward

contracts are obligations, and failure to make or take delivery of the underlying asset represents default.

In addition, no cash changes hands in a forward contract until the contract settlement date. For these

two reasons, default risk is a concern in forward contracts, and market participants prefer to enter into

such contracts with parties that they know and trust.

Most forward contracts are individually negotiated between corporations and financial intermediaries,

but there are active markets for standard denomination and maturity forward contracts on several

currencies and raw materials that institutions (including the bank market-makers themselves) can use to

hedge their own exposures.

23-2a FORWARD PRICES

The forward price is the price that makes the forward contract have zero net present value (NPV).

The key to determining a security’s fair forward price is being able to form an alternative to the

forward contract that has identical cash flows. For example, consider an asset that pays no income

(such as a discount bond) and does not cost anything to store (such as financial assets). Rather

than buy the asset six months forward, we could borrow the current price of the asset and buy it

today. Six months from now, we would repay the loan plus interest. Whether we buy the asset six

months forward or borrow and buy it today, we end up in the same position – owning the asset in

six months. Because both strategies have identical cash flows in all circumstances, we can make

LO23.2

forward price
The price to which parties in
a forward contract agree. The
price at which a purchaser will
buy a specified amount of an
asset from the seller at a fixed
date in the future

spot price
The price that the buyer pays
the seller today in a cash
market transaction

settlement date
The date on which the buyer
pays the seller and the seller
delivers the asset to the buyer.
In a forward contract, this
will be an agreed date in the
future