Forward Contract Settlement Example: Understanding the Basics
If you are involved in trading or investments, you may have heard of forward contracts. A forward contract is a binding agreement between two parties to buy or sell an asset at a predetermined price, date, and quantity in the future. One of the critical aspects of a forward contract is the settlement process, which involves the exchange of the asset and payment between the parties.
In this article, we will discuss the forward contract settlement process and provide an example to help you understand how it works.
Forward Contract Settlement Process
The settlement process of a forward contract is straightforward. It involves the delivery of the underlying asset by the seller and the payment by the buyer at the predetermined price and date. The settlement date can be any date in the future, ranging from a few days to several years.
There are two types of settlement methods in a forward contract:
1. Physical Delivery Settlement
In a physical delivery settlement, the buyer and seller exchange the underlying asset and payment on the settlement date. For instance, if the underlying asset is gold, the seller delivers gold to the buyer, and the buyer pays the agreed-upon price.
2. Cash Settlement
In a cash settlement, the buyer and seller do not exchange the underlying asset physically. Instead, they settle the contract by transferring the price difference between the contract price and the market price on the settlement date. For example, if the agreed-upon price for a barrel of crude oil in a forward contract is $65, and the market price on the settlement date is $70, the seller pays $5 to the buyer.
The settlement method depends on the underlying asset and its availability for delivery, the market conditions, and the trader`s preference.
Forward Contract Settlement Example
Suppose that a company wants to import machinery from China in six months and is concerned about the fluctuation in the currency exchange rate. To mitigate this risk, the company enters into a forward contract with a bank to buy Chinese yuan at a predetermined price of $0.15 per yuan in six months, which is the settlement date.
Assume that the current exchange rate is $0.14 per yuan, and the forward contract is for the purchase of 100,000 yuan. On the settlement date, there are two possible scenarios:
1. If the exchange rate has decreased to $0.13 per yuan, the company will pay $13,000 to the bank ($0.13 x 100,000 yuan) and receive 100,000 yuan to pay the Chinese supplier. The company benefits from the lower exchange rate, and the bank bears the loss.
2. If the exchange rate has increased to $0.16 per yuan, the company will pay $16,000 to the bank ($0.16 x 100,000 yuan) and receive 100,000 yuan to pay the Chinese supplier. The company bears the loss, and the bank benefits from the higher exchange rate.
Conclusion
In summary, a forward contract is an essential tool in managing financial risks and securing future trading or investment. The settlement process involves the exchange of the underlying asset and payment, either through physical delivery or cash payment, depending on the contract`s terms and market conditions. By understanding the forward contract settlement process and its example, traders and investors can better understand the risks and benefits involved in this type of contract.
