Many equity forward contracts are based on a stock index. For example, consider a U.K. asset manager who wants to protect the value of her portfolio that is a Financial Times Stock Exchange 100 index fund, or who wants to eliminate a risk for which the FTSE 100 Index is a sufficiently accurate representation of the risk she wishes to eliminate. For example, the manager may be anticipating the sale of a number of U.K. blue chip shares at a future date. The manager could, as in our stock portfolio example, take a specific portfolio of stocks to a forward contract dealer and obtain a forward contract on that portfolio. She realizes, however, that a forward contract on a widely accepted benchmark would result in a better price quote, because the dealer can more easily hedge the risk with other transactions. Moreover, the manager is not even sure which stocks she will still be holding at the later date. She simply knows that she will sell a certain amount of stock at a later date and believes that the FTSE 100 is representative of the stock that she will sell. The manager is concerned with the systematic risk associated with the U.K. stock market, and accordingly, she decides that selling a forward contract on the FTSE 100 would be a good way to manage the risk. Assume that the portfolio manager decides to protect £15,000,000 of stock. The dealer quotes a price of £6,000 on a forward contract covering £15,000,000. We assume that the contract will be cash settled because such index contracts are nearly always done that way. When the contract expiration date arrives, let us say that the index is at £5,925- a decrease of 1.25 percent from the forward price. Because the manager is short the contract and its price went down, the transaction makes money. But how much did it make on a notional principal of £15,000,000?
The index declined by 1.25 percent. Thus, the transaction should make 0.0125 X £15,000,000 = £187,500. In other words, the dealer would have to pay £187,500 in cash. If the portfolio were a FTSE 100 index fund, then it would be viewed as a portfolio initially worth £15,000,000 that declined by 1.25 percent, a loss of £187,500. The forward contract offsets this loss. Of course, in reality, the portfolio is not an index fund and such a hedge is not perfect, but as noted above, there are sometimes reasons for preferring that the forward contract be based on an index.