A payoff profile shows the scenarios under which a trade will make money and the scenarios under which a trade will lose money.
In the most common case it is a simple graph that plots the change in price of the underlying security on the horizontal axis and the change in price of the derivative security on the vertical axis
Depending on the type of the instrument the changes in value may be linear or non linear. In our case the horizontal and vertical axis have the same units implying that the change in value is linear.
The horizontal axis tracks the change in the value of the underlying. The vertical axis tracks the change in value of the derivative instrument. O or origin represents the current underlying price and the change in the underlying as well as as the derivative instrument is marked in a single unit (+1, +2, +3).
For most contract types, this simple tool can be used to highlight the cashflow profile of a transaction type. We use the same tool for Forwards, Futures, Interest Rate Swaps and Options as well as to dissect exotic products into more basic forms.
The Payoff profile for a forward contract
A long position (you are a buyer) forward contract is used when you wish to hedge yourself against the risk of rising prices in the future. A short position (you are a seller) is used when you wish to hedge yourself against the risk of falling prices in the future. The next four figures walk through the calculation of payoff profiles for a long forward contract.
There are four quadrants, I, II, III, IV, rotating clockwise through the grid above.
- Quadrant I – Underlying prices fall, derivative value increases
- Quadrant II – Underlying prices rise, derivative value rises
- Quadrant III – Underlying prices fall, derivative value falls
- Quadrant IV – Underlying prices rise, derivative value falls
In the case of a forward contract, the resulting payoff profile across all four quadrants is the same as if you actually own and hold the security. The value of your portfolio increases as the underlying prices rise and decreases as the underlying prices falls.