Valuation of Forward Contracts

Instructor: LEROY (Bill) RANDS

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

Forward contracts are basic derivatives that are used by both international companies and financial institutions to hedge risk and focus on future transactions. Calculation of value for forward contracts is discussed in this lesson.

What Are Forward Contracts?

Derivatives are very complex financial instruments available to investors. Investors take buy or sell positions on assets or financial instruments that they do not own, betting on the movement in price of the underlying asset.

A form of derivative is a forward contract. A forward contract differs from most derivatives in that it is entered into between two parties to sell and buy a certain amount of a commodity, currency or financial asset at some future date for a set price. The intent of the forward contract is to lock in a price of the asset for the benefit of both parties, or one party might be willing to take a risk on the final spot or market price.

The market for forward contracts is unregulated and is considered an over-the-counter market. Since the transaction is between two parties, the size of the market is unknown but is estimated to be huge because international companies and financial institutions use forward contracts daily to hedge currency and interest rate risk.

Forward contracts can be tailored as very complex financial instruments. The breadth and depth of these contracts expands when any type of financial instrument, such as stocks, bonds, treasuries, interest rate, etc., can be used in forward contracts.

Forward vs. Future Contracts

Forward and futures contracts have many similarities. Both contracts involve an agreement to buy or sell a commodity at some set price in future, so investors in both are speculating on the price of that commodity at some future date.

However, a futures contract trades on an exchange. A futures contract profit and loss settles on a daily basis based on the trade price. There are futures contracts available for most of the major commodities, such as corn, wheat, oranges, oil, etc. Investors in futures contracts are taking long or short positions on the price of the commodity, betting on the price movement for the commodity over time.

Calculation of Value for Forward Contracts

A forward contract, as stated, is a contract between two parties for the sale/delivery of a fixed amount of a commodity or asset at a future date for a set price. The value of the contract is set and the transaction is settled between the two parties.

The value of a forward contract at initial negotiation is zero. The contract has no value until the contract is terminated or one party chooses to settle. Since it is not traded on any exchange, it has no value to either party when it is initiated.

Growing Inc. sells a forward contract to sell 2,000,000 bushels of corn to Financial LLC for $4.30 a bushel on September 5. The value of that contract at settlement is $8.6 million.

  • $4.30 × 2,000,000 bushels = $8,600,000

On September 5, if the spot price for corn is $4.30, Growing Inc. and Financial LLC would settle the contract without either party owing the other anything.

However, if the spot price for corn was $5.00 on September 5, Growing Inc. would owe Financial LLC $1.4 million as a result of the difference between the spot price and the contract price.

  • ($5 - $4.30) × 2,000,000 bushels = $1,400,000

The opposite would be true if the spot price was $3.50. Growing Inc. would owe Financial LLC $1.6 million at settlement.

  • ($3.50 - $4.30) × 2,000,000 bushels = -$1,600,000

Sellers and buyers of commodities often use forward contracts as a means of locking in the selling price for a seller and locking in the buying price/manufacturing cost for a buyer.

Another Example

XYZ Corp., a U.S. company, has just signed a contract to buy a piece of equipment from Elite Corp., a French company, for 500,000 euros in six months. XYZ Corp will have to convert dollars into euros to satisfy the contract. Let's say that one U.S. dollar is worth 1.25 euros at the time the contract is signed. That means that it would take $400,000 to buy the 500,000 euros.

XYZ can wait until it has to pay for the equipment in six months and then go to its bank and convert dollars into euros to pay Elite. But let's say the value of the euro versus the dollar has dropped to 1:1.05 - i.e., the value of the dollar has dropped. Now XYZ will have to pay $476,190 for the 500,000 euros. The piece of machinery just cost XYZ $76,000 more because of the drop in value of the dollar.

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