When trading in stocks and commodities, there are two types of trades – spot trades and derivatives.
Spot trades are when you buy or sell the security at the prevailing market price. Derivatives, on the other hand, are those that derive their values from security or an asset. These contracts involve buying or selling the assets at a later date at a specified price.
Forward contracts are a type of derivative contract that can be in stocks, commodities or even foreign currency.
Let’s understand what these contracts are and how they work.
What are Forward Contracts?
Forward contracts are contracts between two parties – the buyers and sellers. Under the contract, a specified asset is agreed to be traded at a later date at a specified price.
For example, you enter into a contract to sell 100 units of a computer to another party after 2 months at Rs. 50,000 per unit. You enter into a forward contract. After 2 months, the buyer would pay you Rs. 50 lakh for the agreed 100 units of computer and settle the contract.
How do Forward Contracts Work?
To understand the workings of a forward contract, you need to understand the different components of the same. The basic components of a forward contract include the following –
This is the security (stock, commodities, index or currency) that is traded. The value of the forward contract is derived from the value of the underlying asset.
The price at which the contract is agreed to be executed. This price is usually calculated by adding the risk-free rate of return to the market price of the asset.
There are two parties to a forward contract – the buyer and the seller.
The specified date at which the contract is to be executed is called the future date.
Trading Principal of a Forward Contract
Once these components are worked out, the contract is drawn. The trading principle behind a forward contract is simple:
- The buyer believes that the future price of the underlying asset will increase in future. That is why he enters the contract at the forward price, which is lower than the expected price of the asset in future. If his predictions come true, he can buy the asset at a lower rate. And then sell it at a higher rate to make a profit.For example,a forward contract is drawn between the buyer and seller for 100 kgs of wheat at Rs. 30/kg. The buyer expects the price of the wheat to rise beyond Rs. 30/kg. If, on the contract execution date, the market price of wheat is Rs. 32/kg, the buyer makes a profit. He can buy 100 kgs at Rs. 30 and then sell them at Rs. 32, thereby making a profit of Rs. 2/kg.
- The seller, on the other hand, believes the price of the asset to fall at a later date. That is why, for security, he locks in a higher price to sell the asset. If the seller’s prediction does come true and the price falls, the seller would not make a loss since he locked in a higher price when entering into the forward contract.For example, in the aforementioned instance, the seller expects the price of wheat to fall to Rs. 28/kg. If it happens, the seller would stand to make a gain of Rs. 2/kg as he would be able to sell his wheat at a price higher than the market price.
Thus in a forward contract, the buyer and seller have opposing views with respect to the price of the underlying asset. One party expects the price to rise, while the other expects it to fall. So at the time of execution, one party makes a gain while the other suffers a loss.
The forward contract can be settled by the actual delivery of the underlying asset or in cash, wherein one party pays the differential cash to another.
Difference Between Forward and Future Contract
A forward contract sounds very much like a futures contract, but it is not the same. While both are types of derivatives, they are quite different from one another. Here’s how –
Forwards | Futures |
| They are not traded on the stock exchange. | They are traded on the exchange |
| It can be customised depending on the needs of the buyer and the seller | Futures are standardized contracts |
| A clearinghouse is not involved | A clearinghouse is involved in the settlement of futures |
| They are settled at a specified date | Futures can be traded whenever the exchange is open |
Takeaway
Forward contracts are traded extensively as they are relevant for both buyers and sellers. If you also want to trade forwards, understand their means and their workings so you can make informed investment decisions.
FAQs
What Is a Forward Contract? A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.
What is an example of a forward contract? ›
For example, an investor enters into a forward contract to purchase 10 euros at a price of 15 US dollars today. The person selling 10 euros will deliver the assets on the agreed upon date. Forward contracts are usually traded in secondary markets between participating parties and not very common on centralized markets.
How does a forward rate agreement work? ›
A FRA is an agreement between you and the Bank to exchange the net difference between a fixed rate of interest and a floating rate of interest. This exchange is based on the notional amount you require for the term nominated. The net difference between the two interest rates is applied against the underlying borrowing.
How does a forward market work? ›
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market.
Why would you use a forward contract? ›
A Forward Contract may be beneficial for business and individuals if exchange rates are particularly attractive now, and you want to lock in that rate to hedge against uncertainty in the future.
What is a forward contract basis? ›
Forward contracts are privately negotiated agreements between a buyer and a seller to trade an asset at a future date at a given price. 1 They don't trade on an exchange and have more flexible terms and conditions, including the amount of the underlying asset and how it will be delivered.
What are the problems of a forward contract? ›
Their use is limited by three major problems with forward contracts: (1) it is often costly/difficult to find a willing counterparty; (2) the market for forwards is illiquid due to their idiosyncratic nature so they are not easily sold to other parties if desired; (3) one party usually has an incentive to break the ...
What are the two types of forward contracts? ›
Forward Contracts can broadly be classified as 'Fixed Date Forward Contracts' and 'Option Forward Contracts'. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date.
What are the risks involved in forward contracts? ›
Risks involved while trading in Forwards Include, liquidity risk, default risk, regulatory risk and lack of flexibility. The main areas of differences between Forwards and Futures lie in their contract terms, their default risk, regulation, initial margin and settlement.
What is a disadvantage of a forward contract? ›
Lack of flexibility: One of the biggest disadvantages of using forward contracts is that they lack flexibility. Once a business has entered into a forward contract, they are obligated to buy or sell the currency at the agreed-upon rate, regardless of whether the exchange rate has moved in their favor or not.
Forward contracts can be used to lock in a specific price to avoid volatility in pricing. The party who buys a forward contract is entering into a long position, and the party selling a forward contract enters into a short position. If the price of the underlying asset increases, the long position benefits.
What are two disadvantages of a forward exchange contract? ›
Disadvantages of forward foreign exchange contracts
- You have to go ahead with the contract once you have arranged it, regardless of whether your circ*mstances change.
- Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate.
At the conclusion of the contract, all outstanding issues must be resolved in accordance with the conditions. Every forward contract has the potential to have its own unique stipulations. Derivatives like this are not traded like stocks on an exchange. Rather, they are considered over-the-counter transactions.
What is the price of a forward contract? ›
Forward price is the price at which a seller delivers an underlying asset, financial derivative, or currency to the buyer of a forward contract at a predetermined date. It is roughly equal to the spot price plus associated carrying costs such as storage costs, interest rates, etc.
Are the parties involved in a forward contract obligated to? ›
However, unlike an options contract, the two parties involved in a forwards derivative contract are obligated to fulfil the specified transaction and take the delivery of the underlying asset.
What are the problems with forward contracts? ›
Their use is limited by three major problems with forward contracts: (1) it is often costly/difficult to find a willing counterparty; (2) the market for forwards is illiquid due to their idiosyncratic nature so they are not easily sold to other parties if desired; (3) one party usually has an incentive to break the ...
What is the main feature of a forward contract? ›
A forward contract is a financial agreement between two parties to buy or sell a specific asset at a fixed price and date in the future. It is a derivatives asset with underlying security which can be stocks, market indices, commodities, foreign currency, etc.
Can you break a forward contract? ›
Should you decide to terminate a Forward Contract prior to the maturity date (for example, in the event that the underlying transaction will not be completed), you will transact an equal and opposite transaction in order to reverse the agreed exchange.
