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2.5. An example

example of forward deal

Figure 4: example of forward deal

A forward transaction is effected on 18 September (T+0). On this day the spot price of a basket of maize (corn) is LCC100. A consumer (buyer) believes that the price of maize (his favorite food) will be much higher in three months' time (because of an anticipated drought). He would thus like to secure a price now for a basket of maize he would like to purchase in three months' time.

The farmer (producer and seller), on the other hand, believes that the price of maize will decline (because he anticipates plenty of rain). The farmer quotes the buyer a price of LCC103.74, i.e. he undertakes to supply the buyer with one basket of maize on 18 December (after 91 days) for a consideration (price) of LCC103.74. This figure the farmer arrived at by taking into account the interest rate he is paying the bank for a loan used to produce the mielies. Assuming the interest rate to be 15.0% pa, he calculates the forward price according to the following formula (= cost of carry model):

where

FP = forward price SP = spot price

ir = interest rate per annum for the term (expressed as a unit of 1)8 t = term, expressed as number of days / 365 FP = LCC100 x [1 + (0.15 x 91 / 365)]

= LCC100 x (1.037397)

= LCC103.74.

The buyer draws up a contract, which both Mr Farmer and he (Mr Consumer) sign (see Box 1).

Example of forward contract

Box 1: Example of forward contract

On 18 December (after a drought) the price for a basket of maize (i.e. the spot price) has risen to LCC120. The consumer pays the farmer LCC103.74 and takes delivery of the basket of maize. What is the financial position of each party to the forward contract?

The buyer pays LCC103.74. Had he waited until 18 December to purchase his basket of maize, he would have had to pay the spot price of LCC120. If, in the 91-day period, he had "gone off" maize, he will still be happy to purchase the basket at LCC103.74, and this is because he will sell the same basket at LCC120 (the spot price now on 18 December). He thus profits to the extent of LCC16.26 (LCC120 - LCC103.74) (and is annoyed with himself that he did not take a larger "position").

The farmer is thin-lipped because he could have sold the basket of maize on 18 December for LCC120. This does not mean that he made a loss. His production cost, including his carry cost, could only have been, say, LCC95. He thus makes a profit of LCC8.74 (LCC103.74 - LCC95), but it is smaller than he would have made (LCC120 - LCC95.00 = LCC25) in the absence of the forward contract.

Had it rained and the supply of maize increased, the price would most likely have fallen. If we assume the spot price had fallen to LCC90 per basket on 18 December, the farmer is better off (received LCC103.74 as opposed to LCC90), whereas the buyer is worse off (paid LCC103.74 as opposed to LCC90 had he not done the forward deal).

It is important at this stage to attempt to analyse the advantages and disadvantages of forward markets. The main advantages that can be identified are:

• Flexibility with regard to delivery dates.

• Flexibility with regard to size of contract.

The disadvantages are:

• The transaction rests on the integrity of the two parties, i.e. there is a risk of non-performance.

• Both parties are "locked in" to the deal for the duration of the transaction, i.e. they cannot reverse their exposures.

Delivery of the underlying asset took place, i.e. there was no option of settling in cash.

• The quality of the asset may vary.

Transaction costs are high (for example, the consumer visits the farmer at least twice, has a lawyer to draw up the contract, etc.).

2.6. Forward markets

Futures markets developed out of forward markets because of the disadvantages of forward deals. However, forward markets do still exist, and this is because of their advantages as mentioned above and the lack of the disadvantages mentioned above in some markets. The following will make this clear:

• Flexibility with regard to delivery dates.

• Flexibility with regard to size of contract.

• The transaction rests on the integrity of the two parties, but this is not a problem in certain markets where the participants are substantive in terms of capital and expertise (e.g. the forex market).

• Both parties are "locked in" to the deal for the duration of the transaction, but in certain markets they are able to reverse their exposures with other instruments (e.g. futures in the forex market).

• Delivery of the underlying asset is the purpose of doing a forward deal in most cases (i.e. the client does not want the option of settling in cash) (e.g. forex market).

• The quality of the asset does not vary in many cases (e.g. forex market).

• Transaction costs are not high in certain markets (e.g. forex market because of high degree of liquidity).

As will have been guessed, the largest forward market is the forward foreign exchange market. In addition, forward markets exist in the debt market, the share market and in the commodities market. This means that there are forward markets in all the financial markets.

In addition to the forwards that exist in all the financial markets there are also forwards on one of the derivatives, i.e. swaps. The forward markets are discussed under the following sections:

• Forwards in the debt markets.

• Forwards in the share / equity market.

• Forwards in the foreign exchange market.

• Forwards in the commodity markets.

• Forwards on derivatives.

 
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