Equity Forward Contract Example: Understanding the Basics
In the world of finance, equity forward contracts are agreements between two parties to buy or sell a specific amount of a particular equity at a predetermined price and date in the future. These types of contracts are often used by investors, traders, and corporations to hedge their risks or speculate on the future price movements of a stock.
To better understand how equity forward contracts work, let’s take a look at an example:
ABC Corporation is a publicly-traded company whose stock is currently trading at $50 per share. XYZ Investment Company believes that the stock will increase in value over the next six months but wants to protect itself in case the stock price falls. To do this, they enter into an equity forward contract with ABC Corporation to buy 100,000 shares of its stock at $55 per share in six months.
In this scenario, XYZ Investment Company is the buyer, or “long” party, of the equity forward contract, while ABC Corporation is the seller, or “short” party. By agreeing to purchase the stock at a future date for a predetermined price, XYZ Investment Company is protecting itself from any potential price increases in the stock.
If, after six months, ABC Corporation’s stock price has increased to $60 per share, XYZ Investment Company has the right to buy 100,000 shares for $55 each, or a total of $5.5 million. This means that they can sell the shares in the open market for a profit of $500,000 ($60 per share minus $55 per share times 100,000 shares).
On the other hand, if the stock price has fallen to $45 per share, XYZ Investment Company is obligated to buy the 100,000 shares for $55 each, even though they are only worth $45 per share in the open market. This means that they would lose $1 million if they were to sell the shares immediately.
Equity forward contracts can also be used by corporations to raise capital. In this case, the corporation would sell the forward contract to an investor in exchange for cash upfront. The investor would then have the option to buy the corporation’s stock at a predetermined price in the future.
Overall, equity forward contracts can be a valuable tool for investors, traders, and corporations to manage their risks and speculate on the future price movements of a particular equity. However, it is important to understand the terms and conditions of the contract before entering into one to ensure that it aligns with your investment strategy.