An equity forward contract works in the same way as any other forward contract except that it has a stock, a portfolio of stocks or an equity index as the underlying asset. It is an agreement between two parties to buy a pre-specified number of an equity stock (or a portfolio or stock index) at a given price on a given date.
Think of an investor who holds 1,000 shares of Google and wants to sell them after 60 days. Since there is uncertainty about the price of the stock after 60 days, the investor can enter into a forward contract to sell these stocks after 60 days at a price determined today. After 60 days, irrespective of what the market price of the stock is, the investor will have to deliver the stock to the counterparty at the prefixed price.
The equity forwards can be deliverable or cash settled, except when the underlying is an equity index. The forward contract on an equity index will be cash-settled.
To enter into an equity forward contract, the seller or the buyer will have to request a quote from the dealer by providing the stock specifications.
Example – Equity Index Forward Contract
Let’s take an example of an equity index forward contract. Assume that a portfolio manager maintains a portfolio of stocks that closely follows the S&P 500 index. He is expecting to generate $1 million from the portfolio 90 days from now. In order to guarantee a return of $1 million from the portfolio, the portfolio manager can sell (take a short position) in an equity index forward contract. He approaches a dealer and receives a quote of 500 for a notional amount of $1million.
On the settlement date, the index has moved to 480.
Since the portfolio manager has a short position in the forward contract, and the index is below the quoted value of 500, the long will pay the difference to the short.
The index has moved down by (500-480)/500 = 4%.
So, the long will pay 4% of $1million = $40,000 to the short (portfolio manager).
Since the index has moved down, the portfolio manager’s returns from the portfolio will reduce. However, he will gain the equivalent amount from his short position in the forward contract. This way the portfolio manager has achieved his target return of $1million from his portfolio.
A currency forward contract is an agreement between two parties to exchange a certain amount of a currency for another currency at a fixed exchange rate on a fixed future date.
By using a currency forward contract, the parties are able to effectively lock-in the exchange rate for a future transaction.
The currency forward contracts are usually used by exporters and importers to hedge their foreign currency payments from exchange rate fluctuations.
The currency forward contracts can be either deliverable or cash settled. In case of cash settled currency forwards the payment is made by the party who is at loss to the party who is at gain.
Let’s take an example to understand how a currency forward contract works.
Assume a US exporter who is expecting to receive a payment of EUR 10million after 3 months. Since he will need to convert these euros into US dollar, there is exchange rate risk involved. The exporter enters into a cash-settled currency forward contract to exchange 10 million euros into US dollars after 3 months at a fixed exchange rate of 1EUR = 1.2 USD. That means he will be able to exchange his 10 million euros for 12 million US dollars after 3 months.
Now assume that the actual exchange rate after 3 months is 1 EUR = 1.18 USD.
If there were no forward contract, the exporter would have received USD 11.8 million by exchanging EUR 10 million at the market exchange rate.
Since there is a forward contract, the exporter should receive USD 12 million at the rate of 1 EUR = 1.2 USD.
Under the terms of the contract, the counterparty must compensate the exporter by making a payment equivalent to the difference between the fixed rate and the current exchange rate to the exporter. In this case, the exporter will receive USD 0.2 million from the counterparty as cash settlement.
Note that if the US dollar has strengthened instead of weakening, then the exporter would have made the payment to the counterparty.