A portfolio manager is required to sell 31,250 shares of XYZ Inc. in two months. She is concerned that the price of XYZ will decline during the 2-month period, so she enters into a deliverable equity forward contract to sell 31,250 shares of XYZ in a 2 months for EUR160 per share. When the contract expires, XYZ is trading at EUR138 per share. The portfolio manager will most likely:
A. Pay EUR 687,500 to the dealer
B. Receive EUR 4,312,500 from the dealer
C. Receive EUR 5,000,000 from the dealer
The correct answer is C.
I understand the calculation for answer C and C is actualy what I chose in the first place. However, I don’t understand the settlement payment totally - is it okay if the portfolio manager receive EUR 687,500 from the dealder without really selling the shares, instead of receiving EUR 5,000,000 from the dealer? FRA, for instance, only requires the counterparties to pay out the profit or loss. FRA is settled in cash, but no actual loan is made (i.e., it’s just notional loan).
I am confused with the “settlement payment” of various forward, futures, or swap transactions… When should the counterparties pay out the whole amount to really “go through” the transaction? And when should the counterparties just pay out the “differences” (i.e., gain or losses)?
In a forward (or futures) contract the short is obligated to deliver the underlying and the long is obligated to pay for it. It’s your agreement, of course, and you can make any arrangements you want, but you should consider this the default unless told otherwise.
For some forward (or futures) contracts you are told otherwise. Equity index forwards, for example, are generally settled in cash: the long pays the short the difference between the forward price and the spot price at expiration. Similarly for FRAs (as you noted) and single-currency swaps. (In swaps that involve two currencies, the payments are not netted; each party makes its payment in the appropriate currency.)
Nice question. Another observation is that the question specified 'deliverable equity forward contract" so it would be good to lookout for that in the question on the exam.
I was just thinking, that the answers didn’t mention “Receive EURO 687,500 from dealer”. So with answers A & B putting the portfolio manager at a loss, even if you missed out on the “deliverable” part, both A & B don’t make sense anyway.