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Hedging and Speculating with Forward Contracts

The hedging strategy would apply for an owner of the stock. The owner fears a decline of the stock price. He/she can hedge this risk by shorting a forward contract. Doing so implies that he/she has an obligation to deliver the stock at the forward price prevailing for a preset date. As long as the stock price goes below 110, the hedge is winning. Of course, should the price move above the forward price, for example 120, the owner of stock would have to sell at 110 instead of 120, and will lose the 120 - 110, or the positive difference between the future (unknown) spot price and the forward price.

The same forward contract can be used to bet that the future spot price will be above the forward price (will be positive). Consider someone who does not own the stock today. A speculator is willing to bet that the future spot price will be lower than the forward, say 80. The speculator will buy the stock at 80 and sell at 110, making a gain of 30. The forward seller has to deliver the asset tomorrow, whatever its price, since he contracted the obligation to do so. The speculator is exposed to risk, since he/she would lose if the stock price increases above 110, for example 120. Then he/she would buy the stock at 120 and be obligated to sell at 110, making a loss of 110 - 120 — -10. Note that such speculation does not imply any cash outlay when entering into the contract. The difference between the hedger and the speculator is that the former holds the stock while the latter does not.

Payoff of a Forward Contract

The payoff of a forward contract is a horizontal line at maturity, for example 110, when the spot line is the first diagonal and the horizontal axis shows the unknown future spot price. The break-even value making the forward seller win or lose is 110. (See Figure 6.2.) Table 6.2 summarizes the position that a forward buyer or seller would take according to expectations with respect to the future stock price.

 
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