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FORWARD CONTRACTS

A forward contract is a contract that sets the price of an asset for a future date. Being long the forward contract is a commitment to buy the asset, and being short the forward is a commitment to deliver the asset.

A Simple Example of a Forward Contract

Such contracts are very commonplace, as a non-financial example will illustrate. Assume that you buy a book from a bookshop for delivery in approximately 1 month. You commit to pay the bookshop €10 when the book is delivered. You are buying forward and taking delivery in a month from today. The bookseller is selling you a forward since he promises to deliver in a month at €10. The book is the "deliverable instrument." This forward position entails a risk.

Whichever way the price of the book moves, one party has an interest to default because it suffers a loss. If the price of the book drops to €6, the buyer might prefer to buy at €6, and not at original price of €10 from the bookstore. If the price of the book rises to €15, the bookstore has an incentive not to deliver and so default on its commitment to sell to the buyer at €10. Therefore, an incentive, or obligation, is needed to suppress the temptation not to comply.

Future markets are organized markets of forward contracts. Gains and losses are posted on a margin account. The account is credited and debited for the seller and the buyer as above. The accounts of all traders are centralized in the clearinghouse, which is the unique counterparty for all buyers and sellers. The gain or loss is settled on a daily basis. The most that the seller can avoid "paying" is the upward movement of price during one day if it fails to post additional cash, should the opportunity cost of trading forward exceed previous day loss. The cash posted out is adjusted incrementally each day. The cumulative gain or loss of each party is the total gain or loss from the forward contract. By posting losses every day for either the seller or the buyer, the incentives for moving away from the contract are reduced to a one day's loss.

Back to the example, where the buyer makes a gain, the gain is the mirror image of the seller's loss. Hence, the cash posted by the seller is credited to the buyer. Should the price decline, such a decline would reduce the seller's loss and eventually turn it into a gain if the price moves below the forward price preset at the time of sale. If the price of the book starts moving up to 611, the buyer makes a gain of €1 and the seller makes a loss of €1. In an organized market, the seller would have to post the loss as €1 in the dedicated margin account. The loss is cashed out and cannot be avoided by the seller.

 
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