Forward Contract

Situation:
Bala is a rice farmer. He will be harvesting rice in the month of January next year. On September 1, Bala is
uncertain about the price he will receive in January for the rice because the price will depend on the
harvest. If the harvest is poor throughout the country, the price of rice may rise and the farmer will be able
to get a high price for the rice he has produced. On the other hand, if the harvest is good across the country,
the price will be low because of a large supply of rice. Thus, Bala is uncertain about the price he will receive
in January for selling his rice.

Raja is a wholesale rice merchant who buys rice from farmers and sells it to the customers. Raja also faces
a price risk because the price he may have to pay for buying rice from the farmer could either be high or
low, depending upon the harvest.

Since Bala and Raja both face the risk of price uncertainty, it makes sense for them to get together in
September or even earlier and agree upon a price at which Bala will sell the rice to Raja in January. This is
a forward contract because Bala and Raja have agreed upon the time of delivery (January of the next year),
and the price at which the exchange will take place is agreed upon in September for a transaction that will
take place in January of the next year. There will be no exchange of rice or cash in September, and the actual
exchange will take place in January. Thus, both parties will be able to avoid price uncertainty by entering
into a forward contract.

Assume that the price agreed upon by Bala and Raja in September for the delivery in January is INR 25 per
kg. This means that Bala will receive a price of INR 25 per kg of the rice that he sells to Raja, irrespective of
the market price. Similarly, Raja is assured of buying rice at INR 25. Since the price at which Bala will sell
rice is known in September, there is no price risk for Bala. There is no price risk for Raja either since the
price at which Raja will buy the rice is known in September. Suppose that the harvest is poor and the price
of rice in the market in January is INR 32 per kg. Bala will receive only INR 25 from Raja under the
agreement, which will result in a loss of INR 7 per kg for Bala, while Raja will make a gain of INR 7 per kg
of rice. However, if the harvest is very good and the price in January is INR 20 per kg, Bala will gain INR 5
per kg, while Raja will lose INR 5 per kg. This is shown as follows:

Harvest Price Bala Raja

Good 20 5 5
Bad 32 7 7

It is clear that a forward contract assures a price to both the parties for a future transaction; however,
either party could gain or lose from a forward contract because of the movement in the price of the
underlying asset. It should also be noted that the gain for one party will result in a loss of the same amount
for another party.
  Bala would make a gain if the price fell below the forward price of INR 25, while he would make a
loss if the price rose above the forward price of INR 25. If Bala is certain that the price of rice in
January would be below INR 25 per kg, he would enter into a forward contract at the price of INR
25. Thus, the expectation at the time of contract maturity will have an impact on the decision of
whether to hedge or not.
In a similar manner, Raja would enter into the forward contract only if he expects the price of rice in
January to be above INR 25, because he would gain if the price in January is above INR 25.


Bala and Raja agree on September 1 on a forward price of INR 25 per kg of rice, with the delivery date in
January for a quantity of 50 MT. The total value of the contract is 50 × 1000 × 25 = INR 1,250,000. On
January 31, Raja will pay INR 1,250,000 to Bala, who will deliver 50 MT of rice to Raja.

Suppose the harvest that year is very good and rice is sold in the market for INR 20 a kg in the month of
January. Raja could have bought his requirement of 50 MT of rice at INR 20 a kg for a total of INR 1,000,000
from the market. However, in order to honour his obligations under the forward contract, he has to pay
INR 1,250,000. It would cost the merchant INR 250,000 for keeping up his side of the contract.
The fact that the asset price has moved against him is an incentive for the merchant to renege the contract.
If Raja fails to honour the contract, Bala will have to sell rice at the market price of INR 20 and thus will
have incurred a loss of INR 250,000. Thus, non-performance of the contract will make Bala unable to hedge
the price risk.
In a similar manner, Bala will have an opportunity to renege the contract if the price of rice in the market
rises above INR 25 per kg. If the price of rice is INR 30, Bala will receive INR 1,500,000 by selling 50 MT of
rice in the market, instead of receiving only INR 1,250,000 through the forward contract. If Bala reneges
on the contract, Raja will suffer a loss.

To understand how a commodity forward contract can be priced, consider a simple example:
On January 1, Raja realizes that he will need 20 MT of rice on July 1. Raja has three options to get
this rice on July 1.

Alternative 1: Not do anything until July 1, and purchase 20 MT of rice on July 1 at the prevailing market
price P1
Alternative 2: On January 1, enter into a forward contract to buy 20 MT of rice on July 1 at a forward price
Alternative 3: Buy 20 MT of rice on January 1 at the price of p0, which is the price of rice in the market
today, and keep it stored in a warehouse. This price p0 is also known as the spot price at time 0.

Among these alternatives, the first alternative is risky because the price of rice on July 1 is not known on
January 1, whereas this price risk has been eliminated in alternatives 2 and 3. In alternative 2, the forward
price f0, which is the price at which the rice will be bought on July 1, is decided today and hence this price
is known with certainty. In alternative 3, the rice is being bought today at the spot price, which is also
known with certainty. However, buying rice on January 1 at the spot price requires that the rice be stored
in the warehouse until July 1, and this would mean incurring storage costs. Thus, the price that is paid today
should be adjusted for the storage costs when considering the cost of using this strategy.


Since alternatives 2 and 3 do not result in any risk, both of them must result in the same cost to the buyer,

f0 = p0 + c

where,

f0 is the forward price;

p0 is the current spot price of the underlying commodity; and
c is the cost of carrying the commodity from the day on which the contract is entered into
until
the delivery date of the forward contract.

The cost of carry includes:

1. The actual cost of storage in the warehouse, including warehouse rent
2. The expenses in connection with storage, such as freight and insurance
3. The opportunity cost of funds invested in buying the goods

Assume that the spot price on January 1 is INR 22 per kg, and buying 20 MT of rice will require an
investment of 20 × 22 × 1000 = INR 440,000. This amount will be needed for investment today. On the
other hand, if the futures price is INR 25 per kg, the amount of 25 × 20 × 1000 = INR 500,000 will have to
be paid only on July 1. The amount of INR 440,000 can be invested today in other financial instruments
that can offer a positive return.

The rate at which the amount can be invested today at no risk is known as the opportunity cost, and this
cost should also be taken into consideration in the cost of carry.
Usually, the cost of carry is expressed as a percentage of the spot price.

Question:
Sun Jewellers, a gold jewellery manufacturer, requires 1,000 grams of gold on July 1. On April 1, the price
of gold is INR 12,000 per gram. It plans to enter into a forward contract to buy gold, with the delivery date
of July 1. It has estimated that the storage of this gold will cost INR 80,000 and that it can invest its funds
at 8% elsewhere. Calculate the forward price of gold on April 1 for delivery on July 1.

Question:
A palm oil trader wants to enter into a forward contract on June 1, for delivery on July 1. The spot price of
palm oil is INR 50 per litre, and the trader wants to buy 10,000 litres of oil. If the cost of carry is 4% of the
spot price, what will be the forward price?