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Becoming Familiar With Forward Contracts

Becoming Familiar With Forward Contracts. Objectives. Explain the two types of contracts List and explain the parts of a contract Understand and explain a forward contract. What is a Contract?. A legally enforceable arrangement or agreement between two or more parties.

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Becoming Familiar With Forward Contracts

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  1. Becoming Familiar With Forward Contracts

  2. Objectives • Explain the two types of contracts • List and explain the parts of a contract • Understand and explain a forward contract

  3. What is a Contract? • A legally enforceable arrangement or agreement between two or more parties

  4. What are the two types of contracts? • Expressed • parties state the terms of the contract orally or in writing • Inferred • the actions or conduct of the parties indicate and intention to contract

  5. Four Essential Elements of an Enforceable Contract • Two or more legal parties • Must be mentally competent • Must be legal age under the state law • Offer and Acceptance • Evidence all parties intend to be bound by agreement • Usually an offer by one party and accepted by the other party • Sufficient Consideration • A promise • May be money, goods, or a promise for a promise • Must be lawful – not offend public policy or morals

  6. Forward Contracts • is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. • no actual cash or assest changes hands until the maturity of the contract

  7. Example of how the payoff of a forward contract works • Suppose that Bob wants to buy a house in one year's time. At the same time, suppose that Andy currently owns a house that he wishes to sell in one year's time. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.

  8. Example of how the payoff of a forward contract works • At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognise that Bob can buy from Andy for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a loss of $6,000. To see why this is so, one needs only recognise that Andy could have sold to the open market $110,000 rather than Bob for $104,000. Unfortunately for Andy, he is legally obliged to sell to Bob at the lower price.

  9. Review • Is the example we looked at an expressed or implied contract? WHY

  10. Review • Identify the essential parts of a contract in the example • Two Parties: • Andy, Bob • Offer and Acceptance • 104,000 for a house • Sufficient Consideration • One year • Must be Lawful

  11. Review • Is this example a forward Contract? WHY

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