Introduction

Forward contract is a non-standardized agreement between two parties to sell or by an

underlying asset and the delivery to be made at a specific future date with the price being set
today. Forward contract plays an important role in mitigating the default risk between the parties
involved in the market.

Ways of reducing risks in the forward market

Hedging – uncertainty in changes in exchange rates is eliminated with the use of forward
contract as it enables an individual to know ahead of time. This is regardless of market changes,
the parties are able to exchange at a fixed rate.

Close out netting – this is a standard strategy of mitigating risk in the forward contract where it
allows the amounts owed to a counterparty to be offset with the amount owed to another party. In
this case, the parties have an obligation to one another so that in the event that one party defaults
on his/her obligations, the outstanding contract is terminated and then marked to market and
therefore settled with the net proceeds.

Guarantee- the use of a suitable personnel as a guarantor mitigates the risk of default. This makes
the contract more attractive as a guarantor provide risk mitigation in the event of default.

Selectivity in choosing the counterparty- counterparties with excellent credit qualities are chosen.
The credit worthy persons has low default risk while the defaulters are highly risky. Because of
the asymmetric information between the parties in the contract, there is need to analyze the
worthiness of each other as a way of reducing risks of default.

Collateralized transactions- in case of default by the counterparty, the item used as collateral is
sold or owned by the other party to compensate for the damage. For example in the banking
sector, the eligible collateral security may be only cash, title deeds or valuable metals.
 2. Forward contract

Sold forward (360 days) = GBP 1M

CAD
Forward rate = = 1.82
GBP

Sinced the contract has been hedged at, 1CAD = GBP1.82, the amount of CAD to be received in
1000000
future is; = CAD 549451
1.82

Currently (11 months later) the exchange rate is 1CAD = GBP 2.1, hence the amount that could
1000000
have been received without forward contract is; = CAD 476190. An amount which is
2.1
less than when the forward contract was used.

The customer has paid 1 month earlier:

Alternatives;

a) Invest the GBP 1m for one month?

Using GBP currency;

The amount received is GBP 1m. If this amount is invested for 30 days with 18% interest rate,
18 %
then; monthly interest rate is = 1.5%. Then, interest plus principle at the end of the month
12
is; 1000000(1.015) = 1015000. The profit will be 1015000 – 1000000 = GBP15000

Using CAD currency;

In CAD currency, the amount received is CAD 549451. If this amount is invested for one month,
12%
then, the total amount after one month is; 549451(1 + ) = CAD554946. The profit will be
12
CAD 554946 – CAD 549451 = CAD 5495

b) Sell the GBP 1m spot, and negotiate an early termination of the outstanding forward sale

The current exchange rate is 1CAD = GBP 2.1.

Using CAD currency;

The amount received from the contract is CAD 549451. Using the exchange rate above, the
amount of GBP received is CAD 549451 × 2.1 = GBP 1153847. The profit is;

GBP 1153847 – GBP 1000000 = GBP153847

c) Sell the GBP 1m spot, and buy them forward 30 days so as to deliver the required amount
to the bank.

Selling the GBP 1m will yield GBP 1153847 from (b) above. Buying them forward 30 days so
that the forward contract obligation is exercised, GBP 1m will be paid and the remaining

GBP153847 is the profit. However, the interest rate of 1.5% p.m is foregone. The present value
of the profit to be received one month time at 1.5% discount rate is;

153847
PV = GBP = GBP 151573
(1.015)

The cash flows from the above (a), (b) and (c) are different. This is because in (a), the amount is
received is just invested without utilizing the exchange rate. In (b), the amount is received and
exchange immediately then the contract is terminated. Whereas in (c), the forward contract
amount is received and then sold but bought forward 30 days. This has an effect on the already
known profit.