Understanding the Terms of a Forward Contract The company is a golf course developer that constructs
QUESTION
Understanding the Terms of a Forward ContractThe company is a golf course developer that constructs approximately 10 courses per year. Next year the company will buy 10,000 trees to install in the courses it builds. In recent years, the price of trees has fluctuated wildly. To eliminate this uncertainty, the company has found a reputable financial institution that will enter into a forward contract for 10,000 trees. On January 1 of Year 1, the company agrees to buy 10,000 trees on January 1 of Year 2 from the financial institution. The price is set at $500 per tree. Of course, the financial institution doesnt own any trees. As with most derivative contracts, this agreement will be settled by an exchange of cash on January 1 of Year 2 based on the price of trees on that date. What net amount will the golf course developer pay or receive on January 1 of Year 2 under the forward contract if the price of each tree on that date is (1) $300, (2) $850, and (3) $500? Remember that the forward contract was for 10,000 trees.
Given contract is set is $500 1. The Price of tree on the contract expiring date is $300 The amount paid by golf course developer = Differential in price * no of trees = (500-300)*10000 = $2,000,000 2. The Price of tree on the contract expiring date is $850 >$500 i.e. greaterthan the price agreed by the golf course developer
ANSWER:
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