So here, we will now discuss the payoffs, that was the other objective.

How does the profit and loss at maturity look from entering

first in a long Swiss market in this contract.

And what you have on the horizontal axis of this graph

is the value of the SMI at maturity.

And we enter that contract at a spot price of the SMI

of 7,650 Swiss francs,

when the forward price was quoting at 7,546,

and the contract started the 6th of April 2016,

and actually expired a little bit more than two months later.

So what we see is that at maturity, for any given price of the SMI,

at the maturity date of the forward, which is above the forward price

that is the 7,546, he will make a gain.

Actually, he can make an unlimited gain if the price of the SMI tends to infinity.

Whereas, if the price at maturity of the SMI is below the forward price,

he will make a loss.

So Mr. Smith, if he enters this contract, will have a linear increasing payoff,

which increases as the value of the SMI increases at maturity.

Okay, so now we will look at, let's see, Mr.

Clark, who has exactly the opposite position.

He has sold the forward position on the SMI.

So it means this contract has the same specification you

entered the 6th of April, the maturity date is the 17th of June.

The forward price at the time of the initiation was 7,546.

And we see that if the SMI

is below 7,546, he will make a gain,

although this gain in now limited when the price of the SMI tends to zero.

Whereas, if the price of the SMI is above the forward price,

he could potentially make an unlimited loss.

So let me, to finish, give you a quiz.

So why do we need forwards and, for instance, a forward on the SMI?

So suppose the situation of Mr. Clark, who owns a portfolio,

who replicates the Swiss Market Index.

And he owns this portfolio, and

at the 6th of April he's very worried that over the next two and a half months maybe

the value of the SMI will decline and, thus, he may lose on his portfolio.

So what can he do to protect himself against a drop in the SMI?

Well, you can go home and do the exercise, but I'll give you the answer here.

What he can do is actually combine his long position,

which is the yellow line that is straight up, with a short

position in the forward written on the Swiss Market Index,

and such in a way that he realizes a perfect hedge.

What is a perfect hedge?

It's the light green line on the profit and

loss which just is horizontal at the zero level.

It means that whether the SMI goes up or

down at maturity, he will be totally break even.

No gains, no losses.

For instance, if the SMI declines in value, his portfolio value will decline,

but he will gain, as we saw before, on the short position in the SMI.

So forwards allow you to protect yourself fully, for

instance, in this case against a drop in the Swiss Market Index.

And that's very valuable if you want a very well-diversified portfolio.

So thank you very much for this first introductory lesson into forwards.

I think the key concept is that forwards allow you to hedge,

protect the value of your portfolio gains to drop in an underlying asset's value.

And the second key point was the linear payoffs that you have as a long or

short owner of the SMI forward contract.

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