Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition
VIII. Topics in Corporate
Finance
- Risk Management: An
Introduction to Financial
Engineering
© The McGraw−Hill^813
Companies, 2002
HEDGING WITH FORWARD CONTRACTS
Forward contracts are among the oldest and most basic tools for managing financial
risk. Our goal in this section is to describe forward contracts and discuss how they are
used to hedge financial risk.
Forward Contracts: The Basics
Aforward contractis a legally binding agreement between two parties calling for the
sale of an asset or product in the future at a price agreed upon today. The terms of the
contract call for one party to deliver the goods to the other on a certain date in the future,
called the settlement date.The other party pays the previously agreed-upon forward
priceand takes the goods. Looking back, note that the agreement we discussed between
the wheat grower and the food processor was, in fact, a forward contract.
Forward contracts can be bought and sold. The buyerof a forward contract has the
obligation to take delivery and pay for the goods; the sellerhas the obligation to make
delivery and accept payment. The buyer of a forward contract benefits if prices increase
because the buyer will have locked in a lower price. Similarly, the seller wins if prices
fall because a higher selling price has been locked in. Note that one party to a forward
contract can win only at the expense of the other, so a forward contract is a zero-sum
game.
CONCEPT QUESTIONS
23.2a What is a risk profile? Describe the risk profiles with regard to oil prices for an
oil producer and a gasoline retailer.
23.2bWhat can a firm accomplish by hedging financial risk?
CHAPTER 23 Risk Management: An Introduction to Financial Engineering 787
23.3
FIGURE 23.7
V
B. Seller's perspective
Payoff
profile
V
Payoff
profile
A. Buyer's perspective
Poil
Payoff Profiles for a Forward Contract
forward contract
A legally binding
agreement between two
parties calling for the
sale of an asset or
product in the future at a
price agreed upon today.