Before saying anything about forwards (or forward contracts) we should recall what spot contracts are?
A spot contract is an agreement to buy or sell an asset on the on the spot for an agreed price.
A forward (or forward contract) is an agreement to buy or sell an asset at an agreed future time for an agreed price.
Hedging using Forwards
In the problem we discussed in financial derivative, suppose your company requires 1 million barrel of oil next year. You can hedge your risk by entering a forward contract.
Suppose today is 1 February 2015 and your company agreed to buy 1 million barrels of oil on 1 February 2016 for $80 per barrel (you will pay on 1 February 2016, and oil will be delivered until 10 February 2016). Similarly, the oil company agreed to sell 1 million of oil 1 February 2016 for $80 per barrel.
Payoff in a forward contract
Suppose the market price on 1 February is $82 per barrel, your company gain
82(1 million) – 80(1 million) = $2 million
If the market price of oil on 1 February 2016 is $79 per barrel, then loss of your company is
79(1 million) – 80(1 million) = –$1 million
The negative sign shows that you lost $1 million.
Market and Strike Price
In the above example the agreed price for which the contract is honoured ($80) is called strike price (or simply strike) denoted by K, and the price when contract is actually honoured (on 1 February 2016) is called market price denoted by ST. So, the payoff for your company
Market Price – Strike
As in our example:
1. When Market Price = $82
2. When Market Price = $79
The negative sign shows your company lost $1 million.