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Table of Contents
Table of Contents......................................................................................................................................................1
1. Spot Transaction and Forward Transaction .........................................................................................................1
2. Forward Contract..................................................................................................................................................1
2.0 Introduction......................................................................................................................................................1
2.1 Definition.........................................................................................................................................................1
2.2 Characteristics of a forward contract...............................................................................................................1
2.3 Forward foreign exchange contract ................................................................................................................2
2.4 Forward foreign exchange Option contract .....................................................................................................3
3.0 Introduction......................................................................................................................................................3
3.1 Definition.........................................................................................................................................................3
3.2 Characteristics of Futures Contract.................................................................................................................3
3.3 Types of Futures Contract...............................................................................................................................3
4. Differences between Forward and Futures Contract.............................................................................................3
2. Forward Contract
2.0 Introduction
A forward contract is an agreement between two parties to buy or sell an asset at an agreed price on an agreed date. Hence it is an
obligation for both the parties to fulfill the terms of the agreement at the specified date.
2.1 Definition
“A Forward Transaction is a contractual obligation between two parties where in the transaction takes place today (i.e. Trade Date) and
final settlements takes place at a future date where the terms and exchange rate (in case of a forex) is fixed today.”
Example 2.1.0:
A wants to buy a house after 6 months and B wants to sell his house after the same period ,hence they enter in to a forward agreement
where in B will sell the house to A after 6 months at an agreed price. Now lets say the price of the house as of today is Rs. 100/- and will
rise in future. Hence B has a Risk that if he sells the house today at Rs. 100/- and the price of the house after 6 months is Rs. 104/- he will
have a loss of Rs. 4/- hence he will quote a higher price to A then the current price.
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2.3 Forward foreign exchange contract
When the underlying assets in case of a Forward Contract are two currencies then we call it as a Forward Foreign Exchange Contract. In a
Forward Foreign Exchange Contract two parties agree to buy or sell one currency against the other at an agreed exchange rate on a pre
determined future date. The Forward Exchange rate is calculated for the two currencies based on the following formula:
Ft = S * (1+IR2) / (1+IR1)
Where,
Example 2.3.0:
An importer in India who is importing goods from Japan expects his shipment to reach India after 3 months and therefore needs to make
payment of 100K YEN to a Japanese company after three months. He therefore enter in to a forward contract with ICICI Bank to receive
100K YEN after 3 months at a following rate- 1 INR =1.9491 YEN
Trade Date: 01/01/2009
Settlement Date:
In the foreign exchange market the difference between the spot rate and the forward rate is called a Premium if it is positive and Discount if
it is Negative. In our example the premium is 0.0439.
Example 2.3.1:
Given the following spot FX spot and money market rates, what should be the theoretical 90 day forward FX rate?
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2.4 Forward foreign exchange Option contract
Forward foreign exchange Option contract is similar to a Forward foreign exchange contract except that in this case the settlement may
happen any time in between two agreed date. Hence in the above example if the importer is not sure when exactly he will receive his
shipment however, he is sure that the shipment will reach him between 1/06/2009 to 20/06/2009 he can go for a Forward foreign exchange
Option contract.
In such cases the importer can enter into a Forward foreign exchange Option contract where he has an option to settle the transaction
between two specified dates.(here 1/06/2009 to 20/06/2009) however he has an obligation that he has to settle the transaction in between
the two mentioned dates. Such a contract is called a Forward foreign exchange Option contract.
3. Futures Contract
3.0 Introduction
Futures or futures contracts are derivatives bought or sold on a futures exchange. They are contracts to buy or sell a particular commodity
at a specified price on a certain date in the future. The underlying asset could be commodities, energy, currencies, government bonds or
other financial instruments. The future date on which the contract is executed is known as the final settlement date or the delivery date. The
predetermined price is known as the settlement price.
3.1 Definition
“A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock
index, at a specified price, on a specified future date.”
a. Food products (e.g. cocoa, sugar, corn, soybeans, orange juice, coffee),
b. Precious metals (e.g. gold, silver, platinum, etc),
c. Currencies (e.g. Swiss francs, Deutschmarks, Yen, etc),
d. Stock indexes (e.g. SP500)
e. Financial products (e.g. treasury bonds - to hedge against interest rate fluctuations)