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
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
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
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
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.
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.
Review
Is the example we looked at an
expressed or implied contract?
WHY
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
Review
Is this example a forward Contract?
WHY