Financial literacy: Plain language about securities. Forward: the basis of all derivatives

What you need to know about forward – the first among derivative instruments

The National Securities and Stock Market Commission (NSSMC), together with LIGA.net, has prepared a series of publications to explain the essence and specifics of financial instruments and mechanisms of their use in a simple and accessible manner.

In the previous publication, we discussed the general concept of derivatives, their essence, classification, and life cycle. Now let’s move on to a more detailed analysis of each derivative instrument separately. In this publication, we will focus on the instrument that started hedging risks in trading relationships – the forward.

Economic essence

The forward is part of the first wave of derivatives and was the first derivative instrument to be created. Like other derivatives, forwards arose from the desire of the parties to commodity transactions to reduce the risk of changes in commodity prices.

In essence, a forward is an agreement under which one party undertakes to transfer a specified asset at a certain point in the future to the other party, which undertakes to buy the asset at a predetermined price and on other terms and conditions specified when entering into the forward.

An important aspect of a forward is that it is binding on both parties. That is, this contract imposes obligations on both parties to fulfill it.

In other words, the forward is designed to fix the terms of a future transaction, which makes the economic activities of the parties to the forward predictable and financial planning more accurate, as all parties to the transaction have information about the future trade.

Conclusion and execution of a forward

A forward may be entered into on an organized market or over-the-counter. The party that undertakes to buy the underlying asset opens a long position in the contract, and the party that undertakes to sell the underlying asset opens a short position in the contract.

When expiration occurs, the parties can fulfill the forward in one of two ways:

1. The first method is known as «physical delivery» – the oldest and most straightforward way in which the party to a long position (the buyer) must pay the party to a short position (the seller) for physical delivery of the underlying asset in the future. In other words, it is a method of fulfilling contractual obligations whereby the parties exchange goods or services in a specified quantity, quality and at a specified price.

Physical delivery of forward contracts is a more complicated method of settlement than cash settlement (which we will discuss below) for several reasons:

• The parties must agree on the terms of delivery of the goods or services. This includes things like the place, time, quantity and quality of the goods or services;
• the parties must organize the logistics of delivering the goods or services. This may include transportation, storage and insurance of the goods or services;
• the parties must make sure that the goods or services comply with the terms of the contract. This may require a quality check of the goods or services.

In some cases, physical delivery may not be possible or costly. For example, if the good or service is rare or hard to come by, or if the parties are far apart. In these cases, the parties may agree to settle the forward contract in cash.

However, if physical delivery is possible, it is a safer way to fulfill a forward contract for both parties. This is because the parties do not risk losing money if the price of the goods or services at the time of performance differs from the price agreed upon by the parties when entering into the contract.

2. More complicated to understand, but easier to implement, is the method of forward settlement known as cash settlement. Cash settlement of a forward contract is a method of fulfilling obligations under a contract in which the parties do not exchange goods or services, but simply pay money to each other. This occurs when the price of a good or service at the time of contract execution differs from the price agreed upon by the parties when entering into the contract.

Let us consider examples of cash settlement of forward contracts.

Company A enters into a forward contract with Company B to purchase 1,000 shares of Company X at a price of $100 per share.

After 6 months, at the time of contract execution, the price of Company X’s shares on the market is $120 per share. Thus, due to the forward contract, Company A has to pay $100,000 (1,000 shares * $100) at a spot price of $120,000 (1,000 shares * $120).

Therefore, in this case, Company A will receive compensation from Company B in the amount of $20,000 (1,000 shares * ($120 – $100) per share).

Company K enters into a forward contract with Company M to sell 1,000 barrels of oil at a price of $100 per barrel. After 6 months, at the time of contract execution, the price of oil on the market is $80 per barrel. Thus, due to the forward contract, Company K should receive $100,000 (1,000 barrels * $100) at a spot price of $80,000 (1,000 barrels * $80). Therefore, in this case, Company K will receive compensation from Company M in the amount of $20,000 (1,000 barrels * ($100 – $80) per barrel).

Cash settlement of forward contracts is a popular method of fulfilling obligations because it is simple and convenient. However, it may also be risky for one of the parties to the contract if the price of the goods or services at the time of settlement differs from the price agreed upon by the parties when the contract was entered into.

Thus, depending on the obligation to transfer the underlying asset, a derivative contract may be delivered (involving physical delivery of the underlying asset), settled (involving cash settlement) or mixed (with the possibility to change the method of forward settlement).

Who needs forward contracts?

Forward contracts can be an attractive tool for people who want to make reliable forecasts of their future activities (understanding the price at which they will buy or sell assets in the future) and do not want to take on existing risks.

Forward contracts can be used by various financial market participants, including:

• businesses that want to hedge against the risk of changes in the price of a product or service they are buying or selling. For example, a company that is going to buy wheat can enter into a forward contract to buy wheat at a certain price. This will help the company to fix the price of wheat even if the price of wheat on the market changes;
• investors who want to speculate on changes in the price of a product or service. For example, an investor may enter into a forward contract to buy wheat if he or she believes that the price of wheat will rise. If the price of wheat rises, the investor will be able to make a profit on his forward contract;
• Financial institutions that want to provide liquidity in the market. For example, a broker can enter into a forward contract with a client who wants to buy wheat. This will help the broker provide liquidity in the wheat market.

Forward contracts can be used for various purposes, including:

• protection against price risk;
• speculation on price changes;
• providing liquidity in the market.

Forward contracts are a powerful tool that can be used for risk management and market speculation.

Is there any practice of using forwards in Ukraine?

Ukraine has a long experience of using forwards, and this experience is primarily related to construction financing models. This experience can be divided into two stages: before and after July 1, 2021.

Prior to July 1, 2021, due to gaps in the legal regulation of derivative contracts, parties with long positions (buyers) entered into derivatives purchase and sale agreements. The main reason for the use of such agreements in the past was a provision of tax legislation that provides for a tax benefit for the sale of derivatives.

The situation changed with the entry into force of the new version of Law No. 3480, which enshrined the rule that derivative contracts are «circulated» not by way of purchase and sale, but rather by way of party replacement (a contract for the purchase and sale of a claim under a derivative contract or another contract resulting in the replacement of a party to a derivative contract).

It is worth noting that the NSSMC has previously held this opinion (Letter No. 09/02/7896 dated 29.03.2019).
How did it happen before and how is it happening in Ukraine now?
There are two most common models of using forwards in the construction industry.

Model 1: At the first stage, forwards with the underlying asset in the form of property rights to real estate (usually apartments) were concluded between the developer and a legal entity on a commodity exchange (to form the price of the underlying asset).

At the second stage, these forwards were sold to collective investment institutions (this model was used for forwards concluded before July 1, 2021).

At the third stage, the collective investment institution sold the forward to future apartment owners.

At the fourth stage, the forward holder entered into an agreement with the developer regarding the underlying asset – a contract for the sale and purchase of property rights to the real estate.

At the fourth stage, compliance with the provisions of the Law of Ukraine on Investment Activity (part three of Article 4, which expired on 10.10.2022) is particularly important and problematic, as direct investment in construction was carried out under agreements for the sale and purchase of property rights.

At the same time, other methods (except for construction financing funds, real estate funds, joint investment institutions and corporate bonds) of financing the construction of housing projects using non-state funds raised from individuals and legal entities were to be determined exclusively by laws.

However, the only law that provided for financing of construction through such agreements (sale and purchase of property rights) is the Law as amended on the Promotion of Mortgage Lending (5059-VI of July 05, 2012). But only in terms of financing of unfinished construction projects carried out under budget programs that provide citizens with state support for the construction (purchase) of housing.

Today, this model has undergone changes – forwards are concluded outside the organized market, and «circulation» takes place using contracts for the sale and purchase of the right to claim under a forward contract. The shortcomings of Model 1 led to the emergence of the following model, which is also not without its drawbacks.

Model 2. At the first stage, this model involves the conclusion of a forward contract directly between the developer and the collective investment institution. The difference between this agreement is as follows:

• the underlying asset is not the property rights to the real estate object, but the real estate object itself (apartment), which does not yet exist;
• hedging and payment of the cost/delivery of the underlying asset are carried out under one contract;
• the collective investment institution pays a contingent amount (a premium for the conclusion of the contract or the cost of the contract) when entering into such a contract.

At the second stage, the collective investment vehicle pays the value of the underlying asset.

In the third stage, the collective investment institution sells the contractual rights to the future apartment owners at a margin.

What are the disadvantages of model 2?

First, the forward should not, by its very nature, provide for any payments, as the parties are equal when entering into it and assume mutual obligations.

Secondly, this model involves the use of a mixed contract (Article 628 of the Civil Code), which provides for the conclusion of a contract that has elements of different contracts.

For example, a contract that simultaneously contains the provisions of a derivative instrument (providing for hedging) and the provisions of a contract for the direct purchase and sale of the underlying asset. As we recall from the previous publication: «a derivative (as a hedging instrument) expires at the moment when the parties proceed to its execution.

In other words, if the parties have entered into a transaction (payment/delivery) with respect to the underlying (original) asset, the «wrapper» of the derivative has been unwrapped and the hedge is over».

Thus, the use of a mixed contract should imply that its various parts are governed by the relevant legal provisions. In other words, if the parties have moved to payment and delivery of the underlying asset itself, it is incorrect to continue to apply the rules governing relations with respect to derivatives.

What conclusions can be drawn?

This instrument has great potential and is in demand by businesses. However, in the process of building financial models, the parties primarily take into account tax rules, and then try to take advantage of the lack of regulation of certain instruments and mechanisms.

In such circumstances, the essence of instruments and mechanisms that have long been used in international capital markets is often distorted.

That is why it is very important to provide further explanations of the economic essence and practice of using such instruments. And, of course, it is imperative to bring tax legislation in line with the provisions of Law No. 3480.

In the following publications we will continue to analyze derivative instruments, namely options, option certificates and swaps.

The text was prepared by the NSSMC specifically for LIGA.net.