Payoff on Forward Contracts

Forward contracts are privately executed between two parties. The buyer of the
underlying commodity or asset is referred to as the long side whereas the seller is
the short side. The obligation to buy the asset at the agreed price on the specified
future date is referred to as the long position. A long position profits when prices
rise. The obligation to sell the asset at the agreed price on the specified future date
is referred to as the short position. A short position profits when prices go down.

What is the payoff of a forward contract on the delivery date? Let T denote the
expiration date, K denote the forward price, and PT denote the spot price (or market
price) at the delivery date. Then

 For the long position: the payoff of a forward contract on the delivery date is
PT_ K
 For the short position: the payoff of a forward contract on the delivery date is
K _PT
Figure shows a payoff diagram on a contract forward. Note that both the long and
short forward payoff positions break even when the spot price is equal to the
forward price. Also note that a long forward’s maximum loss is the forward price
whereas the maximum gain is unlimited.

For a short forward, the maximum gain is the forward price and the maximum loss
is unlimited.

Pay0ff diagrams show the pay0ff of a position at expiration. These payoffs do not
include any costs or gains earned when purchasing the assets today. Payoff
diagrams are widely used because they summarize the risk of the position at a
 glance. We have pointed out earlier that the long makes money when the price rises
and the short makes money when the price falls.

Example
An investor sells 20 million yen forward at a forward price of $0.0090 per yen. At
expiration, the spot price is $0.0083 per yen.

1. What is the long position payoff?

2. What is the short position payoff?
Solution.
Forward currency rates

Spot market currencies are exchanged for immediate delivery in the forward rate
market whereas contracts are made to sell or buy currencies for future delivery. For
example, when a company in the U.S. buys goods from England worth in British
Pounds (£), the importer then owes British Pounds (£) for future delivery, let’s say
in 90 days. Assume the current price of British Pounds (£) is $1.71, then there is
the possibility of the British Pounds (£) rising against the U.S. dollar making the
goods to cost more.

The importer can be protected from this risky exchange by quickly negotiating a
90-day forward contract with a bank at a price of, say, £:$ = 1.72. In 90 days, the
bank will provide the importer with £1 million while the importer gives the bank
$1.72. By doing this, the importer is able to convert a short underlying position in
British Pounds (£) to a riskless position and the bank is now taking the risk for a
premium.

Points to Note

 The forward profit or loss contract is not related to the current spot rate of
£:$ = 1.71.
 The profit or loss on the forward contract approximately offsets the change
in the U.S. dollar cost of the good order that is associated with movements in the
GBP’s value.
 The forward contract is not optional. Each party is held to pay the price
quoted in the agreement.

Interest Rate Parity (IRP)

According to the IRP theory, the currency of a nation with a lower interest rate
should be at a forward premium compared to the currency of the nation with a
higher interest rate. Considering a market with no costs of transactions, the interest
differential should be close to equal to the forward differential.

For example, at one point in 2018, the spot euro-dollar exchange rate expressed as
USD/EUR was 1.2775 while the one-year forward rate was 1.27485. This means
that the forward rate was trading at a discount with respect to the spot rate. This is
because the forward rate was smaller compared to the spot rate. Therefore, the one-
year forward points could be quoted as (1.27485 – 1.2775) = -0.00265 = -26.5 pips.

Note that most of the non-Yen exchange rates are always quoted to four decimal
places (the Yen is an exception and is quoted to 2 decimal places for spot rates). In
our case, we scale up the answer by four decimal places by multiplying by 10,000
to get -26.5 pips. The answer is then rounded off to the nearest 1 decimal place.

We can also calculate the forward rate consistent with the spot rate and the interest
rate in each currency. Since the amount of forward points is proportional to the
spread between the foreign and the domestic interest rates if–idif–id, we can evaluate
this relationship as:
f/d−Sf/d=Sf/d[if−id1+idτ)]τFf/d−Sf/d=Sf/d[if−id1+idτ)]τ
F
Example of Calculating the Forward Rate in each Currency
If we want to know the 31-days forward exchange rate from a 31 days domestic
risk-free interest rate of 2.5% per year, given that the foreign 31-days risk-free
interest rate is 3.5% with a spot exchange rate Sf/dSf/d of 1.5630, then we simply
have to substitute these values into the forward rate equation:
F f/d=Sf/d(1+ifτ1+idτ)Ff/d=Sf/d(1+ifτ1+idτ)
F f/d=1.5630(1+0.035×313601+0.025×31360)=1.5643Ff/d=1.5630(1+0.035×313601+0.025×31360)=1.5643
Hence, the forward trading premium is:

F f/d–Sf/d=1.5643–1.5630=0.0013Ff/d–Sf/d=1.5643–1.5630=0.0013
Since forward premiums or discounts are usually quoted in pips or points (1/100 of
1%), multiplying the result by 10,000 will give us 0.0013×10,000=130.0013×10,000=13 pips, which
is the forward trading premium quoted in pips or points.
We can alternatively use the above formula as:

F f/d−Sf/d=1.5630[0.035−0.0251+0.025×31360]×31360=0.001343Ff/d−Sf/d=1.5630[0.035−0.0251+0.025×31360]×31360=0.001343
Which approximately the same as forward trading premium before.