Financial Management of Risks 435contract. A for ward contract specifies an underlying asset to be delivered, a
price to be paid, and the date of delivery. The specified transaction price is
called the for ward price. The party that will be selling wheat (the farmer) is
known as the “short” party; the party that will be buying wheat (the baker)
isknown as the “long” party. In the jargon of the derivatives market, the long
party is said to “buy” the for ward, and the short party “sells” the for ward.
Note, however, that when the deal is initially struck, no money changes hands
and no one has yet bought or sold anything. The “buyer” and “seller” have
agreed to a deferred transaction.
Notice that the wheat for ward reduces risk for both the farmers and the
bakers. In this transaction, both parties are hedgers—that is, they are using
the for ward to reduce risk. For ward contracts are “over-the-counter” instru-
ments, meaning that they are negotiated between two parties and custom-
tailored, rather than traded on exchanges.
Suppose after one month, when the for ward expires and the wheat is deliv-
ered, the current, or spot, price of wheat has risen dramatically. The farmer may
have some regret that he entered into the contract. Had he not sold for ward, he
would have been able to receive more for his wheat by selling on the spot mar-
ket. He may feel like a loser. The bakers, on the other hand, will feel like win-
ners. By contracting for ward they insulated themselves from the rising wheat
price. When spot prices rise, the long party wins while the short party loses. A
little ref lection, however, will convince the farmer that although he lost some
money relative to what he could have gotten on the spot market, going short in
the for ward was indeed a worthwhile strategy. He had piece of mind over the
one month. He was guaranteed a fair price, and he did not have to fear losing the
farm. Though there was an opportunity loss, he benefited by shedding risk. The
farmer probably never regrets that he has never collected on his life insurance
either. He similarly should not regret that the for ward contract represents an op-
portunity loss. He would be well advised to go short again next year.
The wheat for ward contract can be used by speculators as well as
hedgers. An agent who anticipates a rise in wheat prices can profit from that
foresight by going long in the for ward contract. By going long in the contract,
the speculator agrees to buy wheat at the fixed for ward price. Upon expiration
of the contract, the speculator takes delivery of the wheat, pays the for ward
price, and then sells the wheat on the spot market for the higher spot price.
The profit is the difference between the spot and for ward prices. Of course, if
the speculator ’s forecast is wrong, and the wheat price falls, the speculator
would suffer losses equal to the difference between the for ward and spot
price. For example, suppose the initial spot price is $3 per bushel, and the for-
ward price is $3.50 per bushel. If the spot price upon expiration is $4.50 per
bushel, the long speculator would earn a profit of $1 per bushel. The profit is
the terminal spot of $4.50 minus the $3.50 initial forward price. If, alterna-
tively, the terminal spot price is $3.25, the speculator would lose25 cents per
bushel—that is, $3.25 minus $3.50. Notice that the $3 initial spot price is irrel-
evant in both cases.