How does Forward Contract works

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What is forward contract ?

While forward contracts are not very popular among traders and investors today, it is still significant for you to understand the concept as they form the base for futures and option trading. A forward contract is a customized agreement between 2 parties to exchange the underlying asset at a predetermined price and time in the near future.  

Forward Contract

Key Features of Forward Contract

  • There are 2 parties to a forward contract. The buyer and the seller interact directly without the exchange as a counterpart.
  • Both parties must have contrasting or opposite views on the underlying asset.
  • This agreement between the buyer and the seller is customized. For instance, if you buy one lot of future contracts of Infosys, you are agreeing to buy 300 shares of Infosys ltd. But in case of a forward contract, the lot size is not fixed. The lot size can be 100, 200 shares or even 1!
  • While the underlying asset is being exchanged at a future date, the price at which it will be traded is decided today itself.
  • Due to this direct contract, forward contracts are non traded on a stock market. Hence, forward contracts are also referred to as OTC (Over The Counter) derivative contracts.
  • The third thing to note in this definition of forward contract is the underlying asset. Like a future or options, even a forward contract has no value of its own. It derives its value from the underlying asset. The underlying asset in a forward contract can be indices, stocks like commodities, Nifty, Currencies etc.

Working of Forward Contracts

The buyer believes that the future prices of the underlying asset will go up in the near future, That is why he enters into the contract at the forward price which is lower than the expected price of the assets in the future. If his predictions come true, he can buy the asset at a lower rate. And they sell it at a higher rate to make a profit..  

For instance, a forward contract is drawn between the purchaser and seller for 100 kgs of rice at Rs 50 per KG. The buyer expects the price of the rice to rise beyond Rs 50 per kg. If on the contract execution date, the price in the market of rice is Rs 52 per kg, the buyer makes a profit. He can buy 100 kgs at Rs 50 and then sell them at Rs 52 thereby making a profit of Rs 2 per kg.  

On the other hand, the seller believes the price of the asset to fall at a later date.. This is why security locks in a higher price to sell the asset. If the prediction of the seller does come true and the price falls, the seller will not make a loss since he locked in a higher price when entering into the forward contract.  

For instance, in the mentioned instance, the seller expects the price of rice to fall to Rs 48 per Kg. If it happens, the seller will stand to gain Rs 2 per kg as he would be able to sell his rice at a higher price than the market.

Limitations of Forward Contracts

Difficult to find a counterparty:

Forward contracts are not traded or standardized on the stock markets. For instance, one forward contract can be for 100 kgs of rice while another can be 1000 kgs. Due to this customization, finding a counterparty for a specific quantity or price of the underlying asset is time consuming and difficult.  

Default risk:

This is the risk of purchasers and sellers refusing to honor their end of the contract. In the above example, imagine if the price of rice doubles after harvesting, In this case, the seller can decide to not honour the agreement and leave the buyer with nothing. This happens because there is no unbiased 3rd party to settle the contract like in an F/O contract. Since there is no regulatory body involved, default risk is very high in these cases.  

Quality of goods is not standard:

One of the major drawbacks of forward contracts involving agricultural produce is the quality of the underlying asset. You can’t be certain that the quality of rice delivered is the same as committed at the time of entering the forward contract. This might lead to disagreement between the parties and increase the default chances.  

THE CRUX

Forward contracts are used exclusively to hedge against unfavorable price rise like we say in the rice example. But without an unbiased counterparty, forward contracts are extremely risky. The best way to make money from these contrasting views on the same underlying is by using F/O. To trade and make money in the F/O segment, you need to have a demat and trading account.

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Last Updated: 29-Jun-2022

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