Question

For which one of the two parties involved in a forward commitment through a forward contract or a futures contract; are the following market conditions (occurring after inception of the contract) profitable? Explain each in 2 lines:

A. Scarcity of the underlying?

B. Sharp increase in spot price of the underlying?

C. Sharp decrease in spot price of the underlying?

D. Severe inflation?

Answer 1

The two positions involved in a forward or futures contract is the long position, which is the buyer position buying the underlying, and the short position, which is the seller, selling the underlying asset in the contract.

A. Scarcity of underlying

Scarcity of underlying implies that the underlying asset is short in supply. If an asset is short in supply, price of the asset is likely to increase, thus, profitable to the buyer (long position) who has locked in a lower rate (at contract inception) to buy the asset.

B. Sharp increase in spot price of the underlying

Value of long position = Spot price - Present value of Future/Forward price

Therefore, if spot price increases, the long position or buyer is in the profitable position.

C. Sharp decrease in spot price of the underlying

Value of short position = Present value of Future/Forward price - Spot price

Therefore, if spot price decreases, the short position or the seller is in the profitable position.

D. Severe Inflation

Inflation leads to a general increase in prices of goods and services, thus, it would most likely be profitable to the long position in a forwards or futures contract. Impact of inflation on forwards and futures contracts is not seen in short term but over longer periods. A severe inflation is usually tackled by the central banks increasing interest rates, thus, reducing the present value of futures/forward prices in the above shown equations. This, too, turns out to be profitable for the buyer in the contract.