Financial matters

TERMINATION OF A FORWARD CONTRACT

Let us note that a forward contract is nearly always constructed with the idea that the participants will hold on to their positions until the contract expires and either engage in delivery of the asset or settle the cash equivalent, as required in the specific contract. The possibility exists, however, that at least one of the participants might wish to terminate the position prior to expiration. For example, suppose a party goes long, meaning that she agrees to buy the asset at the expiration date at the price agreed on at the start, but she subsequently decides to terminate the contract before expiration. We shall assume that the contract calls for delivery rather than cash settlement at expiration.
To see the details of the contract termination, suppose it is part of the way through the life of the contract, and the long decides that she no longer wishes to buy the asset at expiration. She can then re-enter the market and create a new forward contract expiring at the same time as the original forward contract, taking the position of the seller instead. Because of price changes in the market during the period since the original contract was created, this new contract would likely have a different price at which she would have to commit to sell. She would then be long a contract to buy the asset at expiration at one price and short a contract to sell the asset at expiration at a different price. It should be apparent that she has no further exposure to the price of the asset.
For example, suppose she is long to buy at $40 and short to deliver at $42. Depending on the characteristics of the contract, one of several possibilities could occur at expiration. Everything could go as planned-the party holding the short position of the contract on which she is long at $40 delivers the asset to her, and she pays him $40. She then delivers the asset to the party who is long the contract on which she is short at $42. That party pays her $42. She nets $2. The transaction is over.
t There is always a possibility that her counterparty on the long contract could default. She is still obligated to deliver the asset on the short contract, for which she will receive I $42. But if her counterparty on the long contract defaults, she has to buy the asset in the market and could suffer a significant loss. There is also a possibility that the counterparty on her short contract could fail to pay her the $42. Of course, she would then not deliver the asset but would be exposed to the risk of changes in the asset’s price. This type of problem illustrates the credit risk in a forward contract.
To avoid the credit risk, when she re-enters the market to go short the forward contract, she could contact the same counterparty with whom she engaged in the long forward contract. They could agree to cancel both contracts. Because she would be owed $2 at expiration, cancellation of the contract would result in the counterparty paying her the present value of $2. This termination or offset of the original forward position is clearly desirable for both counterparties because it eliminates the credit risk. It is always possible, however, that she might receive a better price from another counterparty. If that price is sufficiently attractive and she does not perceive the credit risk to be too high, she may choose to deal with the other counterparty and leave the credit risk in the picture.