What is Forward Contract
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- Updated 23 Aug 2023
A forward contract is a popular financial agreement used in investing and trading. It is a contractual agreement between two parties, usually individuals or entities, to purchase or sell an asset at a particular price on a future date. Unlike other types of financial instruments, forward contracts are not traded on an exchange but are customized agreements between the buyer and seller.
Forward Contract Meaning and Example
In this contract, the buyer and seller agree on the terms of the contract, including the asset being traded, the price at which it will be bought or sold, and the delivery date. This agreement is legally binding, and both parties need to fulfill the terms of the contract on the specified date. Let’s understand it with an example.
Suppose you are a farmer and can proactively manage the risk of falling wheat prices by entering into a forward contract with a grocery store. If you anticipate that wheat prices will decrease in the upcoming months and wish to sell your wheat at Rs. 20.
In this scenario, you initiate a contract with the grocery store, agreeing to sell them a specific quantity of wheat at Rs. 20 after three months.
You secure protection against potential price declines by entering into this forward contract. If the price of wheat indeed drops to Rs. 16, you will still be able to sell your wheat at the contracted rate of Rs. 20. However, if the price of wheat rises instead, you will still receive the price stipulated in the contract.
How Does a Forward Contract Work?
In a forward contract, if the expiration date is reached and the spot price increases, the seller needs to pay the buyer the difference in cost between the forward price and the spot price.
Conversely, if the spot price decreases more than the forward price, the buyer must compensate the seller for the difference. The contract is settled based on specific terms, which may vary for each contract.
There are two methods of settlement: delivery or cash basis settlement.
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In a delivery-based settlement, the seller needs to transfer the underlying asset to the buyer.
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In a cash-based settlement, the buyer is responsible for making the payment on the settlement date, and no exchange of underlying assets takes place.
Advantages of a Forward Contract
1. High Degree of Customization
Forward contracts provide a significant advantage through their ability to be customized according to the parties' requirements. This means that the terms and conditions of the agreement, including the underlying asset, price, and delivery date, can be tailored to suit the unique needs of the buyer and seller. Such flexibility allows businesses and investors to create agreements that precisely address their specific circumstances and preferences.
2. Margin Free Trading
One distinctive characteristic of trading in forward contracts is the absence of a margin requirement. Unlike certain other financial instruments, forward contracts do not necessitate the upfront deposit of a margin. This means that the parties involved can engage in the trading of forward contracts without having to allocate a specific portion of their capital as collateral. As a result, the absence of a margin requirement can lower the initial cost of entering into a forward contract, providing potential cost savings for participants.
Risks Involved in a Forward Contract
1. Absence of Regulatory Authority
Forward contracts are not subject to the governance of a regulatory body. Instead, they rely solely on the agreement reached between the two parties. This lack of oversight means there are no specific rules or guidelines dictating the terms and conditions of the contract.
2. Liquidity Risk
Low liquidity in forward contracts can significantly impact trading decisions. Traders may need help executing their strategies, even if they hold a strong trading view, due to the limited availability of liquidity.
3. Default Risk
The drafting financial institution faces significant risk if the client defaults or fails to settle the forward contract. Buyers and sellers primarily use forward contracts to manage volatility in commodities and other financial investments.
Both parties involved assume higher risks due to the over-the-counter nature of these investments. Traders seeking portfolio diversification beyond stocks and bonds can trade forward contracts.
To Conclude
Forward contracts are valuable investment tools that offer customized agreements for buying or selling assets at predetermined prices on specific dates. Hedgers employ them to manage risk, while speculators seek profit opportunities. Understanding the intricacies and implications of forward contracts is crucial for investors and businesses aiming to mitigate exposure to price fluctuations in various markets. It is advisable to seek consultation from a financial advisor to navigate the complexities of forward contracts effectively.
FAQs
It's an agreement between two parties to purchase or sell an asset at a decided price in the future. It is a legally binding contract that is not traded on an exchange but is privately negotiated.
Forward contracts can involve various types of assets, including commodities such as oil, gold, or wheat, as well as financial instruments like currencies, interest rates, or stock indices.
Forward contracts differ from futures contracts in several ways. Forward contracts are privately negotiated and customizable, whereas futures contracts are standard in nature and traded on exchanges. Forward contracts also have counterparty risk, while futures contracts have margin requirements and daily settlements.
The buyer and seller decide upon the price of a forward contract at the time of contract initiation. It is typically based on the underlying asset's expected future value, considering factors such as supply and demand, market conditions, and risk considerations.
