6. Forward and Futures Contracts.............................
6.1 Forward Contracts........................................
Aforward contractis an agreement to buy or sell an asset on a fixed date
in the future, called thedelivery time, for a price specified in advance, called
theforward price. The party to the contract who agrees to sell the asset is
said to be taking ashort forward position. The other party, obliged to buy the
asset at delivery, is said to have along forward position. The principal reason
for entering into a forward contract is to become independent of the unknown
future price of a risky asset. There are a variety of examples: a farmer wishing
to fix the sale price of his crops in advance, an importer arranging to buy
foreign currency at a fixed rate in the future, a fund manager who wants to sell
stock for a price known in advance. A forward contract is a direct agreement
between two parties. It is typically settled by physical delivery of the asset on
the agreed date. As an alternative, settlement may sometimes be in cash.
Let us denote the time when the forward contract is exchanged by 0,the
delivery time byT,and the forward price byF(0,T).The timetmarket price
of the underlying asset will be denoted byS(t). No payment is made by either
party at time 0, when the forward contract is exchanged. At delivery the party
with a long forward position will benefit ifF(0,T)<S(T). They can buy the
asset forF(0,T) and sell it for the market priceS(T), making an instant profit
ofS(T)−F(0,T). Meanwhile, the party holding a short forward position will
suffer a loss ofS(T)−F(0,T) because they will have to sell below the market
price. IfF(0,T)>S(T),then the situation will be reversed. The payoffs at
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