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Forward Contracts

Finally, forward contracts need not specifically settle by delivery of the underlying asset. They can settle by an exchange of cash. These contracts—called non-deliverable forwards(NDFs), cash-settled forwards, or contracts for differences—have the same economic effect as do their delivery-based counterparts. For example, for a physical delivery contract, if the long pays F0(T) and receives an asset worth ST, the contract is worth STF0(T) to the long at expiration. A non-deliverable forward contract would have the short simply pay cash to the long in the amount of STF0(T). The long would not take possession of the underlying asset, but if he wanted the asset, he could purchase it in the market for its current price of ST. Because he received a cash settlement in the amount of STF0(T), in buying the asset the long would have to pay out only ST – [STF0(T)], which equals F0(T). Thus, the long could acquire the asset, effectively paying F0(T), exactly as the contract promised. Transaction costs do make cash settlement different from physical delivery, but this point is relatively minor and can be disregarded for our purposes here.

As previously mentioned, forward contracts are OTC contracts. There is no formal forward contract exchange. Nonetheless, there are exchange-traded variants of forward contracts, which are called futures contracts or just futures.

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