Hi, Can anyone (I know there is) explain the delivery and settlement of a forward contract? CFAI V6, Ch 71, pg 32 section 1.1. Can’t seems to understand the part on cash settlement. Why does the short has to pay the long $0.25 and not vice-versa? Thanks
with forward contract, delivery does not always happen at the maturity. the two sides choose to settle the ‘net’ in cash. i dont have the book with me… so just use beef as the underlying. suppose, one month ago, you and i entered in to a forward contract. you would pay me $1 for 1kg of beef. hence, you long this beef forward contract. I short it. (no exchange happening here) now, the contract matures. there are two ways of settling it. 1st: you pay me $1, and i give you 1kg of beef (if i dont have any, i have to buy from the market). this is very clear! 2nd: if 1kg of beef worths $1.25 now. just looking at the money: you give me $1 as stated in the contract, and i have to give you 1kg of beef which worths $1.25. instead of transporting the beef to your place, we chose to settle in cash. from you to me: $1 from me to you: $1.25 net effect: i pay you $0.25. hence, short pays long $0.25 basically because of the price increase of beef. but we have locked the price @$1 one month ago. the short experiences a loss. vice versa: if the price of beef today is $0.75, then the long side pays $0.25 to the short side. forward contract is for locking the price at the beginning. it exposes the long side to the risk of price deduction. hope this will help.
Because the underlying asset (bond) is intangible, it is easiest to settle the forward contract in cash. Rather than the short buying the bonds for 98.25 and then delivering them to the long for a price of $98, it is easier for the short just to pay the difference between the agreed upon price and the market value of the asset. The short must pay $0.25 because the increase in the market price of the asset now gives the long the right to buy the bond at a discount. If this contract were to be settled by delivery then the short would buy the bonds for $98.25 and sell them to the long for $98. Essentially, the short is compensating the long for what it will cost him/her to buy the bonds at a price of $98.25. Hope this helps. After looking at this problem in the book I am very glad I chose to cover this material with Schweser.