What are Forward Contracts and How Do They Work?
The business of trading in a financial market of any kind comes with its own set of particular rewards and risks. While the rewards can be reaped with the right amount of research and savvy selection, the risks can seem harder to manage and minimize. In the world of derivatives trading, these risks are often mitigated by traders with the aid of a concept known as a forward contract. These forward contracts are agreements that serve the purpose of hedging and are an essential concept to understand if you are new to trading in derivatives.
So, what is a forward contract and how exactly does it work? Let us take a closer look:
What Is a Forward Contract?
The simple understanding of a forward contract meaning is that it is a specific type of agreement entered into by two parties to purchase or sell an asset at a particular price on a future date. By the virtue of this agreement, the two parties agree to conduct the said transaction in the future, hence the term ‘forward. Similar to a futures contract, the value of the forward contract is derived from the value of the underlying asset, which is why it acts as a derivative. However, it must be noted that unlike an options contract, the two parties involved in forward derivatives contracts are obligated to fulfill the specified transaction.
Forward contracts are not traded on a centralized exchange, which is why they are essentially considered over the counter, or OTC derivatives. This also means that since forward contracts are negotiated privately and without an intermediary, they are more customizable than standard derivative contracts.
How Is Forward Trading Done?
The two parties typically enter into a forward contract because of their opposing views on a particular asset. One party believes that the price of a particular asset is set to rise in the future and therefore wishes to purchase it at a lower, predetermined price to make his profit. Hence, this party offers to be the buyer. The other party, on the other hand, believes that the price of the asset will fall in the coming future and therefore wishes to profit from a predetermined high price for it. This party, therefore, offers to be the seller.
Based on how the market performs and the price of the asset changes, the actual result of the forward contract can typically go in three different ways:
1. The Price Of The Asset Rises In The Future
In this scenario, the buyer’s prediction is proven to be correct and is rewarded with regards to the purchase they make with the forward contract. The profit made by the buyer in this scenario is the difference between the actual current price of the asset and the locked-in price at which the buyer bought it.
2. The Price Of The Asset Falls In The Future
In this scenario, the seller’s prediction is proven to be correct and hence benefits from the sale made through the forward contract. Even though the price of the asset has fallen, the seller gets to sell it at a price higher than its current value. The profit made by the seller in this scenario is the difference between the price at which the seller sells the asset and the actual current price of the asset.
3. The Price Of The Asset Remains Unchanged In The Future
In this scenario, the prediction of neither the buyer nor the seller is proven correct. Therefore, there is no profit made or loss incurred by either party in this transaction.
Example Of Forward Contract
To understand the concept better, let us take a forward contract example. Let’s say a farmer is on track to harvest 20 tons of maize by next year. In order to make a profit on his harvest, he must be able to sell it at a price of at least Rs 10,000 per ton. If the farmer chooses to wait till next year to sell his maize harvest, he may or may not be able to make a profit on the transaction. This is because as the price of the asset, in this case maize, changes, it cannot be guaranteed that his produce will sell at that desired price.
However, if the farmer chooses to enter into a forward contract with a food manufacturing company that guarantees to pay him his desired price in exchange for his harvest next year, his risk is minimized. Therefore, even if the price of maize falls by next year, he will be protected by the obligation of the forward contract and the locked-in selling prices.
Features Of Forward Contracts
Now that you have a better understanding of forward contracts, let us take a look at some of their most essential features:
- There are a number of similarities between forward contracts and future contracts. However, it can be useful to keep a few of their major differences in mind when trading in derivatives. While futures contracts are traded on exchanges, forward contracts are not. As a result, they are also more customisable and allow for specific changes in the agreements with regards to the asset traded, amount and date of delivery.
- Forward derivatives can most often be settled in one of two ways.
- They can either result in physical settlement whereby the seller makes physical delivery of the assets and receives the agreed upon payment by the buyer.
- Alternatively, they can result in cash settlement whereby there is no actual physical delivery of the asset in question. Instead, one of the two parties settles the contract by paying the other an appropriate differential in cash.
- Forward contracts are some of the most commonly employed tools for corporations to minimize and hedge interest rate related risks. They are not as commonly used, however, by individual retail investors and the market remains quite inaccessible to most.
- The market of forward derivatives is essential to various sectors of the country’s economy as not only do they provide price protection but are also simpler to understand and trade with than many other forms of contracts.
- Forward trading typically requires no margin amount and is unregulated by the Securities and Exchange Board of India i.e. SEBI.