Blog: Forward Contracts – A Zero-Sum Game

While many accountants have a negative reaction when the complicated topic of derivatives comes up, CMA exam candidates do not need to be very concerned about derivatives. The CMA exam does not cover the accounting for derivatives, nor does it cover any complex derivatives. The focus for the exam is on forward contracts, futures contracts, and swaps, and using these tools to hedge. If you keep a few basic points in mind, forward contracts will be much easier to understand.

  1. The forward contracts on the CMA exam are like placing a bet about something that will happen in the future. If you think that the market price of something that you want to buy in the future will increase, you can enter into a forward contract to guarantee yourself a purchase price no higher than a certain, agreed-upon amount. You are, in essence, betting that the market price will go up. However, in order to place this bet, you must find someone who has that asset, wants to sell it, and thinks that the market price will go down before they sell it. That person will want to be guaranteed a selling price no lower than a certain amount. You and the other party each believe that the market price will move in opposite directions. When you enter into this forward contract, you have placed a bet on the future market price of the asset.
  2. At the end of the contract, one party will be happy (having won the bet) and the other party will be unhappy (having lost the bet). If the market price is above the “bet” price, the buyer will be happy and the seller will be unhappy. If the market price is lower than the “bet” price, the seller will be happy and the buyer will be unhappy. In other words, these contracts are not win-win situations.
  3. Forward contracts are zero-sum games, meaning that the amount by which the happy party is happy will be the same amount by which the unhappy party is unhappy. For every dollar that one party “wins,” the other party “loses.”

For a simple example, let’s say that Bob wants to buy firewood in four months to heat his home in the winter. Sally has firewood to sell. The current market price for wood is $2,000. Bob and Sally would both like to know the future price of wood in four months so that they can create their budgets for the next six months. Bob is concerned that the market price will go up, and Sally is concerned that the price will go down. So, they agree that in four months Bob will buy wood from Sally for $2,100.

In four months, let us assume that the market price of the wood is $2,300. In this case, Bob is $200 happy because he paid $2,100 instead of $2,300. On the other hand, Sally is $200 unhappy because she could have sold the wood for $2,300 instead of $2,100 if she had not entered into the contract with Bob.

Of course, in real life forward contracts are usually much more complicated, but for the CMA exam this is the foundation that you need to know.