Long Forward Contract Payoff: Profit and Loss at Maturity

Imagine you’re planning a vacation next summer. You find a fantastic deal on a hotel room in a popular beach town, and to lock in that price, you sign an agreement today to pay a certain amount for the room when you arrive next year. This agreement, in a simplified way, is similar to a forward contract.

A forward contract is essentially a customized agreement between two parties to buy or sell an asset at a specific future date, at a price agreed upon today. Think of it as a pre-arranged transaction. The asset could be anything from barrels of oil to bushels of wheat, or even currencies.

Now, let’s talk about taking a ‘long position’ in a forward contract. When an investor goes long in a forward contract, it means they are agreeing to buy the asset at the future date. They are on the buying side of the agreement. They believe the price of the asset will go up in the future.

The ‘payoff profile at maturity’ refers to what happens when the future date of the contract arrives. This is the day of reckoning, so to speak, when the contract is settled. At maturity, the actual market price of the asset, also known as the spot price, is compared to the price that was agreed upon in the forward contract, which is called the forward price.

Let’s illustrate this with an example. Suppose you believe the price of gold is going to rise in the next three months. You enter into a forward contract to buy gold in three months at a price of $2,000 per ounce. This $2,000 is your forward price, the price you’ve locked in today. You are in a long position because you are agreeing to buy.

Three months later, when the contract matures, let’s consider two scenarios.

Scenario one: The spot price of gold in the market is now $2,200 per ounce. Because you have a forward contract to buy gold at $2,000 per ounce, you can effectively buy gold at a cheaper price than the current market price. Your payoff is the difference between the spot price and the forward price. In this case, you would profit $200 per ounce, because $2,200 minus $2,000 equals $200.

Scenario two: The spot price of gold in the market is now $1,800 per ounce. Unfortunately, the price of gold went down instead of up. You are still obligated to buy gold at $2,000 per ounce because of your forward contract. In this situation, you would incur a loss. Your payoff is again the difference between the spot price and the forward price. Here, it would be $1,800 minus $2,000, which results in a loss of $200 per ounce.

Therefore, the payoff profile at maturity for a long position in a forward contract is directly linked to the difference between the spot price of the asset at maturity and the original forward price. If the spot price at maturity is higher than the forward price, the investor in the long position makes a profit. The profit is equal to the spot price minus the forward price. Conversely, if the spot price at maturity is lower than the forward price, the investor in the long position incurs a loss. The loss is equal to the forward price minus the spot price.

In simple terms, for a long forward contract, the investor hopes the spot price at maturity will be higher than the price they agreed to pay. The potential profit is theoretically unlimited, as the spot price could rise indefinitely. However, the potential loss is also significant, though practically limited to the forward price itself in some contexts, but can be substantial depending on the asset and market conditions. The payoff profile is linear, meaning for every dollar the spot price increases above the forward price, the profit increases by a dollar, and for every dollar the spot price decreases below the forward price, the loss increases by a dollar.

This simple payoff structure makes forward contracts useful tools for hedging against price increases or speculating on future price movements. Understanding this payoff profile is crucial for anyone considering using forward contracts in their investment strategy.