Becoming Familiar With Forward Contracts by gio15356


									Becoming Familiar With
Forward Contracts
   Explain the two types of contracts
   List and explain the parts of a contract
   Understand and explain a forward
What is a Contract?
   A legally enforceable arrangement or
   agreement between two or more
What are the two types of
     parties state the terms of the contract
     orally or in writing
     the actions or conduct of the parties
     indicate and intention to contract
Four Essential Elements of an
Enforceable Contract
   Two or more legal parties
      Must be mentally competent
      Must be legal age under the state law
   Offer and Acceptance
      Evidence all parties intend to be bound by agreement
      Usually an offer by one party and accepted by the other
   Sufficient Consideration
      A promise
      May be money, goods, or a promise for a promise
   Must be lawful – not offend public policy or morals
Forward Contracts
   is an agreement between two parties to
   buy or sell an asset (which can be of
   any kind) at a pre-agreed future point
   in time. Therefore, the trade date and
   delivery date are separated.
   no actual cash or assest changes hands
   until the maturity of the contract
Example of how the payoff of a forward
contract works
      Suppose that Bob wants to buy a house in one
      year's time. At the same time, suppose that Andy
      currently owns a house that he wishes to sell in
      one year's time. Both parties could enter into a
      forward contract with each other. Suppose that
      they both agree on the sale price in one year's
      time of $104,000 (more below on why the sale
      price should be this amount). Andy and Bob have
      entered into a forward contract. Bob, because he
      is buying the underlying, is said to have entered a
      long forward contract. Conversely, Andy will have
      the short forward contract.
Example of how the payoff of a forward
contract works
    At the end of one year, suppose that the current
    market valuation of Andy's house is $110,000.
    Then, because Andy is obliged to sell to Bob for only
    $104,000, Bob will make a profit of $6,000. To see
    why this is so, one needs only to recognise that Bob
    can buy from Andy for $104,000 and immediately sell
    to the market for $110,000. Bob has made the
    difference in profit. In contrast, Andy has made a
    loss of $6,000. To see why this is so, one needs only
    recognise that Andy could have sold to the open
    market $110,000 rather than Bob for $104,000.
    Unfortunately for Andy, he is legally obliged to sell to
    Bob at the lower price.
  Is the example we looked at an
  expressed or implied contract?

  Identify the essential parts of a contract
  in the example
  Two Parties:
     Andy, Bob
  Offer and Acceptance
     104,000 for a house
  Sufficient Consideration
     One year
  Must be Lawful
  Is this example a forward Contract?


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