Forward Contracts - Accounting

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1. Learning Objectives

  • Learn the key features of a Forward Contract (FWC).
  • Explain the reasons why an investor would engage in FWC trading.
  • Understand the complete cycle of a FWC trade, including initiating, valuing, liquidating, and taking delivery of a contract.

2. Content

2.1. Key Features of a FWC

A Forward Contract (FWC) is an agreement to buy or sell an asset, typically a currency, at a predetermined price on a future date. Key features of FWCs include:

2.1.1. Underlying Asset: FWCs are often based on currency exchange rates.

2.1.2. Trading Venue: FWCs are traded over-the-counter (OTC), meaning they are privately arranged contracts facilitated by brokers. Despite being OTC, they are highly liquid.

2.1.3. Cash Settlement: Unlike some other derivatives, cash settlement in FWCs occurs on the contract's maturity date rather than during the closing trade. This means that profits or losses are realized only at maturity.

2.2. Why Investors Use FWCs

Hedge funds engage in FWC trading for several reasons:

2.2.1. Portfolio Hedging: Hedge funds often hold diverse securities in various currencies. Fluctuations in currency rates impact the fund's Net Asset Value (NAV) since it is typically issued in the base currency of the fund. FWCs are used to hedge against currency risk. For instance, if a USD fund wishes to invest in a EUR security, it can use a FWC to hedge against potential EUR/USD exchange rate fluctuations.

2.2.2. Speculation: Hedge funds may trade currencies as an asset class. They can speculate on currency price movements, aiming to buy low and sell high.

2.2.3. Hedge Share Class: Hedge funds with multiple share classes may use FWCs to manage currency exposure for specific classes, although this topic is not covered in detail.

2.3. Trading a FWC

2.3.1. Opening and Closing a FWC:

Consider a scenario where a fund believes that the HKD will weaken against the USD in the coming months. On 05/17/06, they enter into a FWC to sell 10,000,000 HKD with a maturity date of 08/30/06 at a rate of 1,291,900 USD.

Each NAV date, the HKD 08/30/06 FWC is priced using Bloomberg forward rates for HKD/USD, and unrealized P/L is recorded on the balance sheet and income statement. Unrealized P/L arises from any movement in HKD/USD rates from the contract's agreed rate.

On 07/13/06, the fund decides to close the entire HKD contract by buying 10,000,000 HKD against 1,288,000 USD. This results in a gain of 3,900 USD, which is recognized as realized P/L on the closing trade date of 07/13/06. A receivable also impacts the balance sheet at this time.

The realized P/L occurs due to the movement in the USD/HKD rate from 0.12919 to 0.1288.

2.3.2. Taking Delivery of the FWC:

In the same example as above, but without the closing entry on 07/13/06, the following would happen:

On 08/30/06, cash movements occur in your broker statement as follows:

  • 10,000,000 HKD is withdrawn from your HKD broker statement (the fund sold HKD).
  • 1,291,900 USD is deposited into your USD broker statement.

These cash movements reflect the settlement of the original FWC contract on the maturity date.

This cycle illustrates how FWCs can be opened, valued, closed, or taken to delivery depending on the fund's strategy and market conditions.

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