By the effect of free market economy, there are several risks which might occur, such as financial risk, maturity risk, exchange risk why natural and legal persons are exposed to huge risks. For this reason, people, financial institutions and companies should preserve themselves from these kinds of risks and get an appropriate position. Derivatives play a significant role in preserving a legal or natural entity against maturity and exchange risks. So, in this article an instrument of these risk management agreements will be summarily explained.
A forward agreement is an agreement which gives a right or an encumbrance to buy/sell a good, a security or an exchange at a predetermined price.[1] The most important function of this agreement type is preserving buyer or seller from risks which are drops or increases of price of contract goods. There are two risks in forward agreements
There are three purposes to make forward agreements: Speculation, Hedging, and Arbitrage.
Some investors make estimations on future prices of some goods. By this way, they enter into a forward agreement with the aim to make a profit. For example if an investor expects that the price of coal will decrease in a time, he will buy a forward agreement on coal and when the expiration date occurs, if the price decrease, the investor will be entitled to buy the coal at pre-concerted price and make a profit.
Hedging means guarantee an investor himself against maturity risk. For instance an investor dealing with gas trade might enter into a forward agreement in order to prevent losses arising from price gaps.
Arbitrage is the process of simultaneous buying and selling of an asset from different platforms, exchanges or locations on different prices (usually small in percentage terms) by cash. While getting into an arbitrage trade, the quantity of the bought and sold underlying asset should be the same. So while an investor enters into a forward agreement which gives a right to buy oil to the owner he might be able to perform another transaction on oil in a different platform at the same time.
In the case, that this transaction is an agreement, it gives several rights and imposes obligations. Therefore parties cannot renege on this agreement without the consent of the counterparty. Actually parties cannot terminate this agreement prior to the expiration date, independently of the consent of the counter party. Parties can extend the term of the contract provided that they mutually agree on.[2]
There are not any options to terminate a forward agreement prior to the expiration date. At the expiration date, the agreement will be automatically terminated by delivery. When the agreement expires, the buyer or seller must comply with his commitment at the pre-concerted price. By delivery of the good in return for the pre-concerted price, the agreement will be over.
A reverse transaction prior to expiration date (Offset) is an option to get rid of the effects of a forward agreement instead of rescission. A party (it can be buyer or seller of the agreement) can enter into another forward agreement on same goods but in reverse location. It means that a buyer must be seller in another agreement to make an offset transaction. By this way the investor can preserve his financial statement.
Parties can independently identify the maturity period, exchange type and etc., because of the trait that these agreements are private commercial agreements. Despite the fact that forward agreements are flexible, parties must comply with making the transactions on negotiated price as per the agreement. For instance an investor has bought a forward agreement imposing that the investor will buy an oil barrel at the price of 100 USD six months later, the investor must comply with this commitment no matter the future price of an oil barrel. If the price of an oil barrel will be 90 USD six months later, an investor will have been made 10 USD profit, because the seller must sell that barrel at this price according to the agreement. Conversely, if an oil barrel’s price will increase to 110 USD, the investor will have been made a loss of 10 USD. Because the investor must buy the barrel at this price in spite the actual price is lower six months later.
Forward agreements are processed in Over-The-Counter markets. This factor makes forward agreements more flexible therefore they are not standard. Forward transactions can be processed between natural entities and legal entities. There is not any restriction on type of parties.
There is not any guarantee such as clearing room for forward agreements. Besides that forward agreements cannot be transferred to third parties.[3] Thus there is not a secondary market for forward agreements. Consequently forward agreements are based on trust. [4]
[1] Don M. CHANCE; An Introduction to Option and Futures, The Dryden Pres, Florida, 1989, s. 20.
[2] Ali CEYLAN; Finansal Teknikler, Ekin Basın Yayın Dağıtım, Bursa, Ekim 2003, s.371
[3] BATI, M.; Are The Forward Contracts Tax Avoidance Tool? S.1220
[4] Ihsan Uğur DELİKANLI; Forward Döviz İşlemleri Vasıtasıyla Mevduat Faiz Gelirinin Peçelenmesi, Vergi Dünyası, Sayı:200, Nisan 1998, s.115.
Legal Intern / Erkam Haşim BULUT
