If a forward contract is to be resolved in cash (non delivery) and the price at expiration is higher than the contract agreement, then the credit risk is borne by the long, since the short has to pay. what is the forward contract is to be resolved with delivery? The person paying is always the long, correct? regardless of the price at expiration?
No, the person “buying” is the long…so if I enter into a Forward with you to 9say) buy 1 KG of rice at 40.00, and at expiration the market price is 45.00, then you owe me 5.00... It basically a fancy bet...the long guy is betting the prices will rise (as that's when he'll benefit) and short guy is betting the prices will fall so he can make money... If we choose the delivery option on the above contract, you'll actually give me 1 KG of rice. If its cash settlement, you give me the 5.00…
these FRA and futures get tricky when you get into currency and interest rate. doing for gold and stuff its easy.
shreya, I get if its cash settlement I’d give you the $5.00. But if its delivery, i’d give you the kg of rice, and you’d give me $40 bucks ?
Yes that’s correct. People get confused in currencies , but it is not that different from gold / stocks /etc (btw gold is being treated like a currency anyway) Lets use EUR/USD for example. If person A is to engage in a forward contract with person B , where A agrees to BUY 1 EURO against USD @ 1.50 in one years time from B. 1 EURO = 1.50 USD That means A is LONG EUR, and B is SHORT EUR or it can also mean A is SHORT USD, and B is LONG USD. But in market practice you will usually use the base currency (which is EUR) to determine the long/short position, to avoid confusion. Say in one year’s time, say if EUR/USD goes up to 2.0 (that means 2 USD per 1 EURO), then person A, the long, benefits. If in physical delivery terms, that just means party A will agree to buy 1 EURO for 1.50 USD from party B. If in cash delivery terms, you will just settle the net payoff. So in this case Party B will PAY Party A 0.50 USD , or If Party A wants the net settlement in EUR, it will be 0.5 / 2.0 = 0.25 EUR. hope this helps.