The Payoff Profile

The payoff profile is the key to understanding how forward contracts and other contracts that we discuss later are used to hedge financial risks. In general, a payoff profile is a plot showing the gains and losses on a contract that result from unexpected price changes. For example, suppose we were examining a forward contract on oil. Based on our discussion, the buyer of the forward contract is obligated to accept delivery of a specified quantity of oil at a future date and pay a set price. Part A of Figure 23.7 shows the resulting payoff profile on the forward contract from the buyer's perspective.

What Figure 23.7 shows is that, as oil prices increase, the buyer of the forward contract benefits by having locked in a lower-than-market price. If oil prices decrease, then the buyer loses because that buyer ends up paying a higher-than-market price. For the seller of the forward contract, things are simply reversed. The payoff profile of the seller is illustrated in Part B of Figure 23.7.

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