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