Revise briefly

1.       We understood that we can enter into a contract to buy or sell something in future.

2.       We can fix the price of those things now itself.

3.       The agreement what we enter either to buy or sell in future is generally known as a “Forward Contract”.

 

Let us take up the yesterday’s scenario once again…to move forward:

Mr X is holding 5000 water bottles
Currently each water bottle is quoted in the market at @$2.00
It is expected that by the end of May, 2016, there can be a shortage of water bottles and Mr Y presumes that the prices of these water bottles may touch $2.50 per bottle.
So Mr Y entered into a forward contract with Mr X to buy 1000 water bottles at $2.25, delivery of the goods being done on: 27.05.2016
Price quoted by Mr X as on 27.04.2016 is		$2.25
Delivery is on:		27.05.2016
Let us assume that we are in May and the date is: 10.05.2016
Prices of water bottles in the market already touched	$2.30
Expected rate of water bottles by 27.05.2016	$2.50

 

What does it mean for us?

Mr Y can buy from Mr X, each water bottle at $2.25, when really in the market prices are likely to be $2.50

Now let us assume one more scenario. We assumed that Mr Y needs 1000 water bottles for a function at his home. Let us assume that function is now cancelled. This implies that Mr Y, instead of using the water bottles for himself, he can buy from Mr X at $2.25 and sell those bottles each at $2.50 per bottle.

Important things to understand: This implies that Mr Y is holding a “Forward Agreement or Forward Contract” that is going to fetch him $250 (1000 X $0.25) after 17 days.

Mr Y is in need of money. Can Mr “Y” sell this “Forward Agreement Contract” to someone else?

The answer is:  YES.

Does it mean that “Forward rate agreements / contracts are traded in the market? The answer is again “YES”.

At what price? That is dependent upon the demand and supply.

The total benefit to Mr Y as on 27.05.2016 would likely to be: (1000 X $0.25) è $250.00

 

 

 

 

 

Let us look into the Counterparty Credit Risk from this Forward Contract Agreement

What is the name of the contract?	Forward Contract
Can Mr X, tell Mr Y, looking into the increase of prices, that “HE WILL NOT SELL”	Yes
Is there any intermediary person / party to see that the Forward Contract conditions are fulfilled?	NO
At the end of the Forward Contract, who is likely to be at gain and who is likely to be at loss?	Mr X is at loss. Because, if he did not agree to sell to Mr Y, he could have sold in the market for $2.50 in the market   Mr Y is at gain. Because, he can buy each bottle at $2.25 and sell at $2.50
What is “mark – to – market”	It is a comparison of the book value to the market value
What is the “Mark – to – Market” or “(MTM)” here for Mr X – Seller as on 27.05.2016?	In the books of Mr X, the value of the Forward Contract is NEGATIVE (Because, the market value of the contract is $2.50 per bottle, but the booked value of the forward contract is: $2.25). The booked value is less than the market value
What is the “Mark – to – Market” or “(MTM)” here for Mr Y (“Buyer”) as on 27.05.2016?	In the books of Mr Y, the value of the Forward Contract is POSITIVE (Because, the booked value of the Forward Contract is $2.25 and its market value is $2.50). The market value is higher than the booked value
How can it be described in Financial Risk Management?	The positive MTM refers to è receivables and it is classified as an ASSET   The negative MTM refers to è payables and it is classified as a LIABILITY
What will happen, if the receivable are not recovered or the asset does not pay us?	We will be running CREDIT RISK
Then can we call “NOT RECEIVING POSITIVE MTM” as CREDIT RISK?	No. This is not credit risk. Because, this positive MTM is not created because of lending. But still there is a chance for not receiving this “POSITIVE MTM”. We call this as “COUNTERPARTY CREDIT RISK”.
When one of the parties (either buyer or seller) is running a negative MTM, can he cancel the contract and run – away?	Yes. Since this is a bi-partite (two party) agreement and there is no “Guarantor” or the intermediary party to see that the contract is fulfilled, the party who is running a negative MTM, can break the contract and run – away.
Then what is the risk to Mr Y, who is running at Positive MTM?	Mr Y is having a risk, because Mr X can break the contract and may Mr Y’s positive MTM may not be realized.
What we learnt today?	We understood about COUNTERPARTY CREDIT RISK