The settlement price of a forward contract is an essential aspect of any forward contract. It is the price at which the underlying asset is sold or bought at the end of the contract.
When a forward contract is created, both the buyer and seller agree to a specific price that will be the settlement price. This price is determined by various factors such as the current market price of the underlying asset, the expected future price, the time to maturity of the contract, and the risk of non-delivery.
A forward contract is settled by physical delivery of the underlying asset or cash settlement. Physical settlement is when the underlying asset is delivered to the buyer, and cash settlement is when the settlement price is paid in cash.
The settlement price is typically determined using the spot price of the underlying asset. The spot price is the current market price of the underlying asset at the time of the settlement.
For example, let`s say a buyer and seller enter into a forward contract for 100 barrels of crude oil. The agreed-upon settlement price is $50 per barrel, and the contract is set to expire in six months. If the spot price of crude oil at the time of settlement is $55 per barrel, the buyer will pay the seller $55 per barrel, and the seller will earn a profit of $5 per barrel.
However, if the spot price of crude oil at the time of settlement is $45 per barrel, the buyer will pay the seller $50 per barrel, and the seller will lose $5 per barrel.
The settlement price plays a significant role in the profitability of a forward contract. If the settlement price is lower than the agreed-upon price, the seller will make a profit, and if it is higher, the buyer will make a profit.
In conclusion, the settlement price of a forward contract is the price at which the underlying asset is sold or bought at the end of the contract. It is determined by various factors, including the spot price of the underlying asset. The settlement price is crucial in determining the profitability of the contract.