What is Forward Contract?
A forward contract is a type of derivative, which is an agreement between two or more parties whose value is tied to an underlying asset. For instance, the underlying assets for the derivatives can be commodities, foreign currency, market indices, stocks, etc.
In a forward contract, a buyer and seller agree to buy or sell an underlying asset at a specific price on a future date. Both parties agree to conduct the transaction in future, hence termed as ‘forward’. Also, the specific price is called the forward price. Furthermore, the buyer takes a long position, and the seller takes a short position.
Generally, this contract is used for hedging or speculation. This is because it helps the parties involved to manage volatility by locking the price for the underlying assets. Also, they do not trade on a stock exchange and are considered over-the-counter instruments because they are customised.
The forward contract consists of four major components. They are –
- Asset: The underlying asset specified in the contract, which can be a commodity, currency, index, stock, etc.
- Quantity: It refers to the size of the contract, i.e. the specific amount of units of assets being bought and sold.
- Price: It is the price which will be paid at the expiration date. Also, it includes the currency of payment that will be rendered in.
- Expiration Date: This is the end date when the contract is settled and the asset is delivered and paid.
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Features of Forward Contract
The following are the essential features of a forward contract –
- These are not standardized and are not traded on a stock exchange. Also, the parties can make changes in the agreement with regard to the underlying assets, amount and delivery date. Thus, they are customizable.
- The parties can settle these contracts in one of the ways. One is where the seller makes the physical delivery of assets and receives the agreed payment from the buyer. The other is cash settlement, where there is no physical delivery of the asset. It is one of the parties paying to settle the contract with the appropriate differential cash.
- Corporations mostly use these contracts to minimize and hedge interest rate risk. This prevents them from purchasing an asset at a higher price in future.
- Forward trading requires no margin as SEBI does not regulate it. Thus, it is easy to trade and customizable.
How Does a Forward Contract Work?
Let us understand how a forward contract works with the help of an example. A farmer has 1000 kgs of wheat to sell at Rs.30/kg to make profits. If the farmer waits till next year, he may or may not be able to profit from the transaction. This is because no one can predict the wheat price next year.
Thus, the farmer decides to enter into a forward contract with a manufacturing company that promises to pay him a specific price (Rs.30/kg) in exchange for wheat next year. So even if the wheat price falls the next year, the farmer is protected by the obligation of a forward contract. Also, he will receive a higher price compared to the market.
Generally, the two parties enter into a forward contract because of their opposing views on a future price of a particular asset. One party believes the price will rise in the future, and the other believes the price will fall in the future. So at the time of execution, one party makes a profit while another party incurs a loss. Based on the market conditions and the price of an asset, the forward contract result can go in three ways –
Asset Price Increases in Future
The buyer feels that the future price of wheat might increase in future. Thus, the buyer enters into a contract at a forward price which is lower than the expected price in future. If the predictions come true, the buyer can buy the wheat at a lower price and then sell it at a higher price in the open market to make a profit.
Asset Price Falls in Future
The seller (farmer) feels that the price of wheat may fall in future. For security, the seller locks them at a higher price to sell the wheat (asset). If the seller’s predictions come true and the price falls, the seller would not make a loss as he fixed it at a higher price while entering the forward contract.
Asset Price Remains Unchanged in Future
The prediction of the buyer and seller is not correct. Therefore, the transaction results in no loss and no profit by either of the parties.
What are Forward Contracts Used For?
The forward contract is primarily used to hedge against potential losses. It enables the participants to lock the asset price in future. This future price is very important, especially in industries that experience significant volatility in prices. For instance, in the oil industry, entering into a forward contract to sell a specific number of oil barrels can be used to protect against the potential downward swings in oil prices. Moreover, these contracts are mainly used to hedge against the changes in currency exchange rates while making international transactions.
Alternatively, forward contracts can also be used for speculative purposes. This is not very common because these contacts are created by two parties and are not available for trading on stock exchanges. If the speculator believes that the future spot price of the asset will be higher than the forward price today, they may enter into a long forward position. Also, if the future spot price exceeds the agreed contract price, they will profit.
Advantages and Risks of a Forward Contract
The following are the advantages of a forward contract –
- Hedging: The preset specifications in the agreement made by the parties allow them to manage risks and protect themselves from market fluctuations that can affect the asset price.
- Customization: The parties involved in the agreement make specific requirements, including expiry date, lot size and pricing.
- Simplicity: These are simpler to understand the price protection and enable proximity among traders with less regulation.
The following are the risks involved in a forward contract –
- Regulatory Risk: These are executed with the mutual consent of both parties involved. Also, they are not governed by any specific regulatory authority. Because there is no regulatory authority, it increases the risk ability of either of the parties to default.
- Liquidity Risk: The trading decision is impacted in these contracts due to low liquidity. Even though the trader has a strong trading view, they may not be able to execute the strategy because of low liquidity.
- Default Risk: The institution that drafted the agreement is exposed to a high level of risk in the event of default or non-settlement by the client. Thus, these are risky for both parties as it is over the counter investments.
Frequently Asked Questions
Yes, you can cancel the forward contract on or before its expiration date.
Yes, you can extend a forward contract on or before its expiration date.
A forward hedge is another term used for forward contracts to fix a price today for an asset to be bought or sold at a later date.
A forward contract is a private and customisable contract that is only settled at the end of the period (expiration date) and traded over the counter. In contrast, a futures contract is standardised and traded on the exchange, where prices are settled on a daily basis until the contract ends.