What are Forward Contracts and How Do They Work?

Last Updated: 17 Jan 2025

The Indian financial market and its numerous investment instruments come with their risks and rewards. While investors can reap the rewards with the right amount of research and an ideal trading strategy, the risks can seem harder to manage and minimise if the investors are not well versed with the financial market. In the world of derivatives trading, these risks are often mitigated by traders with the aid of a forward contract.So, what is a forward contract, and how does it work? Let’s take a closer look:

What Is a Forward Contract?

A forwards contract is a specific agreement by two parties to purchase or sell an asset at a particular price on a future date. The two parties agree to conduct the said transaction in the future, hence the term ‘forward’. The value of the forward contract is derived from the underlying asset’s value, such as stocks, commodities, currencies, etc. This is why a forward contract acts as a derivative. 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.

Forward contracts are not traded on a centralised exchange, which is why they are essentially considered over-the-counter or OTC derivatives. Furthermore, since forward contracts are negotiated privately and without an intermediary, they are more customisable than standard derivative contracts.

Features Of a Forward Contract

Having understood what is forward contracts definition, let’s see what forward contract features are:-

1)Over The Counter (OTC) and Non Standardised

Forward contracts are not available for stock exchange and stay non-standardised. This is why these contracts can be modified by parties to cater for their needs like price, undisclosed assets, date of delivery, etc.

2)Modifiable Agreements

The above-mentioned aspects can also be customised according to the needs of the party, making the contract more adaptable and unique according to the needs of contracting parties.

3)Settlement Choices

Amongst the many forward contract features, settlements too can be done in two ways – Physical Delivery and Settlement with cash. The seller gives real assets to the purchaser, who pays a pre-decided amount in physical delivery. Cash settlement is just paying the difference to settle forward contracts.

4)Risk Mitigation For Corporates

Mitigating and hedging against risk is the main reason corporates utilise forward contracts. It helps to nullify the negative impact of buying an asset at a higher cost in future.

5)No Requirement For Margin

A margin is not necessary for forward trading. This is because it is not operated by the Securities and Exchange Board of India (SEBI). This makes the process of trading easier with multiple modifications.

Understanding forward contracts

Here is a list of forward contract features that are important to understand:-

1)Terminologies Of Forward Contracts

• Asset – Particular asset that is mentioned in the agreement (cash, commodity, security, etc.)
• Expiry Date – Contract obligations are to be completed on a pre-decided date.
• Amount – The assigned quantity of underlying assets that has to be sold or purchased.
• Cost – The pre-decided cost of trading the asset on the expiry date. Also mentions the currency of the transaction.

2)Key Aspects

• OTC (Over-The Counter) – Forward contracts are not exchanged on centralised platforms. They are dealt with by the parties directly.
• Settlement – When the asset is exchanged with the decided price, the contract is considered settled. When the difference in cost is traded, cash settlements may take place.

This is how forward contracts are made and settled.

Applications of forward contracts

There are two key applications of a forward contract:-

1)Hedging

To get assured in a volatile market, people can fix their future prices. This is done to defend against losses that could occur due to price changes. This helps in damage control provided by forward contracts.

2)Exchange Rate Of Currency Hedging

When dealing with international trades, a forward contract helps to manage the threat of changing currency rates.

Forward Contract Trading Basics

The essential rule behind forward contracts is to bolt in a future cost nowadays, notwithstanding market changes. This can be particularly important in unstable markets, where costs can swing significantly over brief periods. By entering into a forward contract, both parties commit to the agreed-upon terms, independent of how showcase conditions advance. This can give a sense of market security and consistency in questionable financial climates.

Example Of a Forwards Contract
Parties Involved:
– Buyer: Company X (an Indian textile manufacturer)
– Seller: Farmer Y (an Indian cotton farmer)

Underlying Asset: 10,000 kilograms of cotton

Contract Date: January 15, 2025

Settlement Date: July 15, 2025 (six months later)

Forward Price: ₹200 per kilogram

Obligations:
– Company X commits to buying 10,000 kilograms of cotton on July 15, 2025, at ₹200 per kilogram.
– Farmer Y commits to delivering 10,000 kilograms of cotton on July 15, 2025, at ₹200 per kilogram.

Purpose: Hedging against future price fluctuations in cotton prices.

Potential Outcomes:
– If the market price on July 15, 2025, is ₹250 per kilogram:
– Company X benefits by paying ₹200 per kilogram (saving ₹50 per kilogram).
– Farmer Y loses potential revenue as he could have sold at ₹250 per kilogram.

– If the market price on July 15, 2025, is ₹150 per kilogram:
– Company X incurs a loss by paying ₹200 per kilogram (overpaying by ₹50 per kilogram).
– Farmer Y benefits by selling at ₹200 per kilogram (gaining ₹50 per kilogram).

This is how a forwards contract can help parties manage price risks.

How Is Forward Trading Done?

The two parties typically enter into a forward contract because of their opposing views on a particular asset’s future price. 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 profits based on the price difference. Hence, this party offers to be the buyer. On the other hand, the other party believes that the asset’s price will fall in the near future and therefore wishes to cut their losses by locking in a predetermined price. 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 comes true, and they can sell the asset at a higher price. They take the delivery of the asset by paying the lower predetermined price of the forwards’ contract and sell it on the open market. 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 correct, providing 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, the transaction results in no profit made or loss incurred by either party.

Conclusion

Whether you are a headgear who wants to lock in a predetermined price to cut future losses or a speculator who wants to make profits based on the price fluctuation, a forwards contract is an ideal investment tool. However, since the process can seem complex, it is wise to consult a financial advisor such as IIFL before you start Forwards trading.

Frequently Asked Questions

Q1. What is the difference between a forward contract and hedging?

A forward contract is an intimately negotiated agreement between two parties with terms customised to their specific requirements. Agreement occurs at the contract’s expiration. In discrepancy, a futures contract is standardised and traded on an exchange, with diurnal price adaptations made until the agreement concludes. 

Q2. What is the difference between forward and futures contracts?

A forward contract is a customised agreement to buy or vend an asset at a specific price on a future date. Hedging is a threat operation strategy that involves using fiscal instruments to neutralize implicit losses from price oscillations. While a forward contract can be used for hedging, it’s not synonymous with it. Hedging encompasses colourful fiscal tools and strategies, while a forward contract is just one specific tool. 

Q3. Who uses forward contracts?

Forward contracts are utilized by regulation financial specialists such as fence stores and speculation banks. Subsequently, they are by and large less open to personal retail financial specialists. Upon contract termination, settlement of a forward contract can happen through either physical conveyance of the basic resource or a cash trade.

Q4. What are the limitations of forward contracts?

Forward contracts have several limitations. They are private agreements and hence unregulated, leading to a higher risk of counterparty default. They lack liquidity, making it difficult to trade or exit positions before maturity. The settlement process at expiration can be complex, especially if the market value of the underlying asset differs significantly from the agreed price. Forward contracts require precise specification of terms, and any ambiguity or error can lead to disputes.

Q5. Can forward contract be Cancelled?

Forward contracts can be cancelled, but this generally requires mutual consent between the involved parties. Cancelling a forward contract may involve costs or penalties, depending on the terms of the agreement. Without a mutual agreement, the parties are legally obligated to fulfil the contract terms at maturity.