An equity forward contract is a contract entered into today between two counterparties to agree to trade a fixed quantity of a specific stock or index at a price agreed today, which can also be referred to as the forward price on a date that is also agreed today and locked into that forward contract. To start off with, we're gonna look at some terminology around these forward contracts. The terminology equally applies to any other kind of forward contract, not just specific to equity forwards. When we refer to an underlying asset we are talking about the specific asset that is referred to in the forward contract, which is being agreed to be traded at some point in the future. In terms of the two counterparties for the contract, the counterparty that has agreed to buy the underlying asset on a specific date in the future can be referred to as the long side of the forward contract or to being long of the forward.
The counterparty who has agreed to sell or deliver the underlying assets at that fixed price on that fixed future date is referred to as the short side of the contract or to be short of the forward. Having looked at the fundamentals of an equity forward contract. All of these contract terms are known today. The price and quantity and date in the future on which this transaction is going to take place. However, there is one thing that we don't know which is the price of that underlying stock or index on that future date, it's market price in the future.
The first perspective we're gonna look at is from the position of the long side of the contract and the example we're gonna look at is for a client who's entered into an equity forward contract with a bank where the client has agreed to buy 1000 Microsoft shares. That's our fixed quantity of our specific underlying asset for $75. That is our specified price or forward price and the specific date and when this transaction is gonna take place is in one year's time. From this diagram, we can see that if the underlying asset price here Microsoft stock ends up above $75, the long side of the forward contract will make a profit. So for example, if the stock price were to go up to $85 in one year's time, the long side of the contract would only have to pay the forward price of $75 to take delivery of this Microsoft stock that is worth $85. Making for themselves a $10 gain. However, it is also possible for the long side of a forward contract to suffer a loss. If the stock price went down to let's say $60 then this long side of the contract would still be obligated in one year's time to pay the $75 forward price to take delivery of the stock even though the stock was only worth $60. Conversely, for the short side of the contract the diagram looks like a mirror image around the horizontal access. If the stock price, using the same examples as we had for the long position went up to $85 here, the short side of the contract has to deliver the underlying stock but will only take delivery of $75, the forward price. So we're delivering something that is worth $85 but only getting $75 for it therefore suffering a loss of $10. However, if the underlying stock price went down to $60 here, the short side of the contract would still have to deliver that stock but would receive $75 for it still. They would be delivering something that is only worth $60, but receiving $75 of cash for it which will give again for the short position. This contract is only between these two counterparties the client and the bank in our example. Where one side is making money, the long position, if the underlying set price goes up the short side must be losing the same amount. It's only a contract between those two counterparties.
Equity Derivatives Slides
