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Forward Contract
We start with an example of a simple forward contract. Arctic Fuels, the heating-oil distributor, plans to deliver one million gallons of heating oil to its retail customers next January. Arctic worries about high heating-oil prices next winter and wants to lock in the cost of buying its supply. Northern Refineries is in the opposite position. It will produce heating oil next winter, but doesn't know what the oil can be sold for. So the two firms strike a deal: Arctic Fuels agrees in September to buy one million gallons from Northern Refineries at $1.60 per gallon, to be paid on delivery in January. Northern agrees to sell and deliver one million gallons to Arctic in January at $1.60 per gallon. Arctic and Northern are now the two counterparties in a forward contract. The forward price is $1.60 per gallon. This price is fixed today, in September in our example, but payment and delivery occur later. (The price for immediate delivery is called the spot price Price of asset for immediate delivery (in contrast to forward or futures price).Arctic, which has agreed to buy in January, has the long position in the contract. Northern Refineries, which has agreed to sell in January, has the short position. Both companies have eliminated a business risk: Arctic has locked in its costs, and Northern has locked in its revenues for one million gallons of output. Do not confuse this forward contract with an option. Arctic does not have the option to buy. It has committed to buy, even if spot prices in January turn out much lower than $1.60 per gallon. Northern does not have the option to sell. It cannot back away from the deal, even if spot prices for delivery in January turn out much higher than $1.60 per gallon. Note, however, that both the distributor and refiner have to worry about counterparty risk, that is, the risk that the other party will not perform

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