CFA Level 1 - Derivatives
Procedures for Settling a Forward Contract at Expiration
A forward contact at expiration can be settled in one of two ways:
Example: Settling a Forward Contract
Let's return to our sailboat example from the first part of this section. Assume that at the end of 12 months you are a bit ambivalent about sailing. In this case, you could settle your forward contract with John in one of two ways:
- Physical Delivery - John delivers that sailboat to you and you pay him $150,000, as agreed.
- Cash Settlement - John sends you a check for $35,000. (The difference between your contract's purchase price of $150,000 and the sail boat's current market value of $165,000.)
The same options are available if the current market price is lower than the forward contract's settlement price. If John's sailboat decreases in value to $135,000, you could simply pay John $15,000 to settle the contract, or you could pay him $150,000 and take physical possession of the boat. (You would still suffer a $15,000 loss when you sold the boat for the current price of $135,000.)