Understanding Forward Contracts

Forwards

• A forward is a financial contract between two parties establishing terms for a future transaction.
• Forwards are derivative products.
• Contract terms are firm, obligating both parties to fulfill the transaction as agreed.
• Economic clauses detail the underlying asset, quantity, price, transaction, and settlement dates.
• Market players typically use assets with ISDA legal documentation to reduce legal risks
• Settlement can occur via physical delivery or cash payment.

Physical vs. Cash Settlement

• Physical settlement requires delivering the underlying asset for cash.
• The cash amount to be received is defined in the contract (price × quantity).
• Cash settlement involves one party paying the other the difference between the underlying's price on a set date and time and the contract's transaction price, multiplied by quantity.

Forward Trading and Regulation

• Forwards are traded over-the-counter (OTC).
• Regulations may require central counterparty clearing, such as for Forward Rate Agreements (FRA) involving "large" financial and non-financial counterparties.
• Regulations requires counterparties to exchange initial and variation margins if not cleared.
• Counterparties must report transactions to an authorized Trade Repository (TR).

Economic Role of Forwards

• Forwards allow risk transfer between market participants.
• Market participants use forwards to cover or gain exposure to financial risks, potentially using leverage.
• Financial risks include fluctuations in price, volatility of equity, or interest rate changes, and foreign exchange rate changes

Forwards Market

• Forwards are traded on an over-the-counter (OTC) market.
• Quote-driven trading means only sell-side dealers provide quotes.
• Electronic services like Bloomberg publish these quotes.
• The ask price is the price at which a customer buys, the bid price is the price at which the customer sells.
• The “ask-bid spread” is the difference between ask and bid prices.
• Foreign exchange (FX) forwards are traded on electronic platforms.
• Brokers act as arrangers to allow anonymous order recording for buy-side and sell-side participants.
• Banks act as principals and become official counterparties for customers.
• Post-2007 crisis regulations (Dodd-Frank Act, EMIR, FMIA) require clearing of certain derivative products through authorized counterparties or clearing houses.
• Clearing members' customer transactions must be in segregated accounts at the clearing house enabling easy transfer if a member defaults.
• Default risk shifts to the clearing house when customers trade OTC forwards cleared by a clearing house.
• Clearing houses need members to deposit "margins" to manage counterparty risk.
• Collateral exchanges are required to cover counterparty risk for products that aren't eligible for mandatory clearing
• ISDA credit support documents (CSD) govern these exchanges.
• A margin call is made if collateral doesn't cover counterparty risk.
• The party liquidates contracts with the defaulting counterparty if collateral is not delivered on time.
• Margins are usually passed on to customers by banks.

Forward Positions

• Reverse transactions or unwinding (early termination) reduce or close a forward position.
• Unwinding needs both parties' agreement and involves cash settlement, with a likely compensatory amount.
• Reverse transactions involve a new contract with identical economic clauses.
• Reverse transactions require contracts to remain open until maturity.
• Settlement occurs on the original contract's settlement date with a reverse transaction.
• Parties must adjust derivatives for corporate actions on the underlying.
• Adjustment methods mirror clearing houses and ISDA may issue instructions to coordinate and protect market players from legal risk.

FX Forwards

• An FX forward is a contract to exchange currencies at a future date different from the spot value date (t+2 or t+1).
• Negotiated conditions include currencies, amount, exchange rate, and settlement date.
• Parties commit to exchanging amounts of currency 1 for currency 2 at a specified rate on a future date.
• The FX rate is set on the contract conclusion date for the transaction settlement date:
• Commercial enterprises use FX forwards mainly to hedge exchange rate risk on future payments or income in foreign currencies.

Initial Margin

• Forwards cleared by a clearing house has an initial margin for clearing house losses when liquidating a defaulting member's positions given forward value changes between trading days
• Calculation estimates implicit market risk of member's open contracts with the clearing house.
• Clearing houses publish initial margin parameters for financial products on their websites, based on a risk model (VaR).
• The worst-case scenario value of the underlying defines the forward contract's value.
• Securities or cash can cover the initial margin and the broker or depositary bank's risk policy dictates whether the initial margin is passed on to the customer.

Regulatory Initial Margin

• Forwards not cleared by a clearing house has a regulatory, initial margin and an independent amount.
• The Independent Amount (IA) refers to the initial margin required by the clearing house before regulation.
• Parties define IA calculation parameters in the ISDA credit support annex (CSA) or by the customer's depositary bank.
• Since some forwards now require initial margins under regulation, users must differentiate between regulatory required initial margin (RegIM) and negotiated initial margin (IA).
• RegIM calculation parameters are regulatory defined, but counterparties can use a supervisory authority-approved model.
• Eligible collateral is required for RegIM coverage and the broker/depositary bank's risk policy dictates whether the RegIM is passed on to the customer.

Variation Margin

• The variation margin covers losses incurred by the non-defaulting party by trading if the other party defaults.
• The variation margin on a forward equates to the contract's replacement value or unrealized gain/loss.
• Variation margin is usually calculated daily.
• Unrealized gains on derivative contracts can offset unrealized losses on other contracts to arrive at a net variation margin, based on the clearing process (OTC or clearing house).
• Settlement is in cash or securities as per clearing house rules/regulations or ISDA credit support annex (CSA) criteria for uncleared OTC derivatives.
• The broker/depositary bank's risk policy dictates whether the variation margin is passed on to the customer.

Transaction Value Date

• The value date of initial margins is when the contract is concluded.
• The value date of variation margins is the margin calculation date.
• Forward transaction settlement depends on the settlement cycles of the underlying.
• If an equity is settled on t+2, the forward transaction's settlement is T+2 (T = contract maturity date).

Cash Flow Components for the Investor

• On contract conclusion: Initial margin (if required by regulation).
• Over the life of the contract: Variation margin (usually each trading day).
• When the contract matures: Cash settlement or physical delivery, return of initial margin, and any execution fees.

Taxes

• There is no turnover tax (stamp duty) on forward transactions in Switzerland.
• Some countries have a transaction tax.
• Capital gains tax may be collected based on the customer's country of tax domicile and tax status.
• The customer may face clearing fees (covering both the clearing house and clearing member). Clearing fees from clearing houses are available to view. Bank clearing fees are based on the institution’s remuneration policies
• Customers can be charged for collateral/margin and reporting management. The former can be from financial institutions while the latter can be from regulations (e.g. Dodd-Frank Act, EMIR, FMIA)
• These regulations require forward transactions and positions to be reported to an authorized trade repository.

Leverage

• Forwards provides the ability for market players to implicitly benefit from leverage.
• Leverage represents the percentage rate of return on the cash invested vs. percentage rate of growth of the underlying.
• Forwards give exposure to the underlying with a small initial cash.
• Ex post leverage is calculated via: (Return on cash invested)/(percentage growth of underlying)
• Leverage of 10, means that if the price of the underlying rises (falls) by 1 percent, the return on cash invested is +10 percent (-10 percent).

Constraints on Investing in Forwards

• Asset management mandate gives implicit leverage, meaning that the large losses that could be incurred can limit the investment use.
• This suggests that the forward should not produce more leverage than the entire portfolio. The customer bears the responsibility for maintaining sufficient cash or securities.
• If an investment manager sells 10 Nestle with a forward, they must hold 10 Nestle shares.
• The investment policy of funds always indicates the constraints on products.
• Ensure customers understand risks with forwards.

Advisory and Execution-Only mandate

• Insurance that the customer must possess the best understanding regarding forwards to ensure trading success.
• Institutions must inform customers and sign documentation and it is especially important to refer to institutions regulations on forwards

Investment Risks

• Maximum loss depends on the underlying asset and the position assumed (long or short).
• Theoretically the maximum loss is less for short positions in equity forwards.
• Customer undertakes payments that are notably greater than the amount invested when the contract was concluded

Price Risk of Underlying Asset

• Derived from the price, as these contracts are derivatives
• Leverage from the forwards are amplified when they occur as a directly underlying investment

Counterparty Risks

• Arises from parties not performing duties agreed to in the initial contract, if the counterparty becomes insolvent.
• Risks arise due to the possibility of a clearing house default, or if the intermediary brokers and banks become insolvent.
• Risks can arise if the initial margin is segregated from the customer's cash if the counterparty defaults.

Fellow Customer Risk

• Cleared forwards can give risks that depositors collateral is to compensate for the losses of another customer.
• Risks arise from the member's customer and any member defaulting, and the collateral is lost.
• Risks reduced if positions are kept in a protected clearing house.

Basis Risk

• The risk of customer's forward contract doesn't have risk cover due to risk exposure.

Operational Risks

• Arises from faulty clauses in the contract being delivered.

Legal Risks

• Guidelines are needed to the management mandate and that the customer must hold knowledge forwards.
• Compliance is required with duty of the information and the event defaulting is transferred.

Liquidity Risk

• Failing to meet the initial margin, resulting in closure of positions.
• The absence of cash is required to define tasks.
• The reimbursement if the contract terminates is the risk of not being able to pay.
• The risks that securities used are not being returned and a lack of quoting on the markets can also create market manipulation.

Tax Risks

• Relevant to how cashflows affect transactions.

Country Risk

• The country to which the contravening contract is under is insolvent, due to political disputes. The customer is then placed under scrutiny if unstable.

Credit Risks

• The regulations used by the country affect and allow the other country to unfairly use transparency, making it more likely to have quality credit and create warrents.