A Forward Contract is an over-the-counter agreement between two parties to buy or sell an asset at a particular time in the future for a specific price. The terms-long hedge and short hedge refer to whether a party to a forward contract is a buyer or a seller.
- The party that has agreed to buy in anticipation of a possible increase in the price of an underlying asset is said to have a long position.
- The party that has agreed to sell in anticipation of a possible decline in the price of an underlying asset is said to have a short position.
The distinguishing characteristic of a forward contract is that they are not traded on any exchange. They are therefore called “over-the-counter.” Dealers bring together the buyer and the seller, who then negotiate the terms of the contract.
How is a Forward Contact Settled?
Settlement of the forward contract can occur either by cash or by delivery. In addition to the cash payment from the buyer, an agreement made on a delivery basis will require the seller to supply the asset to the buyer on the settlement date. On the other hand, a contract made on a cash basis merely requires a cash settlement between the buyer and seller on the settlement date. The cash settlement amount is based on the difference between the current market price and the agreed contract price. If the market and contract prices are the same on the settlement date, no money changes hands, and the contract is closed.
Examples of Forward Contracts
One of the most common forward contracts involves the sale of a commodity. Suppose a farmer wishes to sell 100,000 bales of cotton in six months. He wants to lock in the price now, so he enters into a forward contract with a buyer to sell 100,000 bales of cotton in six months for INR 10 Lakhs, i.e., Rs 10 per bale. In six months, cotton production is plentiful and sells for INR 9 per head on the open market. The 100,000 bales of cotton are only worth INR 9 Lakhs. Despite this, the buyer has agreed to pay INR 10 Lakhs. If the settlement is made on a cash basis, the buyer pays the farmer Rs 1 lakh, which is the difference between the contract price of INR 10 Lakhs and the market price of INR 9 Lakhs. The farmer then sells the cotton bales on the open market for INR 9 Lakhs to collect a total of INR 10 Lakhs.
In another form, forward contracts are used to facilitate international trade. The increase in international trade has created an enormous market for hedging with forward contracts to minimize foreign exchange risk. Consider the following example of a foreign currency forward contract.
An Indian Company has sold 1000 laptops to a south Asian country for USD 100,000 due in three months. The Indian company is concerned about the appreciation of the USD from the current date until the date payment is received. Therefore, the Indian company enters into a forward contract to sell USD 100,000 in three months. This will enable the Indian company to lock in the exchange rate at the time of the sale, even though the company will not receive payment for the laptops for another three months.
Difference between a Forward and Futures Contract
|Forward Contract||Futures Contract|
|Contract Terms||Customized T&Cs.(i.e., negotiated for each contract)||Standardized T&Cs(i.e., common for all participants)|
|Settlement||Daily Settlement- Not Applicable, i.e., no MTMFinal Settlement- on the contract expiry date||Daily Settlement- Applicable, i.e., MTM is done on a T+1 basisFinal Settlement- on the contract expiry date, i.e., on a T+2 basis|
|Delivery||It could be settled by delivery or in cash. Depends on the contract specifications.||Delivery depends on an underlying asset. For some underlying, it could be cash-settled, and for others, it could be delivery based. The exchange or related entity manages delivery.|
|Collateral||None||Initial Margin Required|
|Credit Risk||Depends upon the parties involved in the forward contract.||None, because the exchange is a counterparty to every trade, and that of the clearinghouse replaces the creditworthiness of the original counterparty.|
|Market Participants||Large firms only||Wide variety of participants, like individuals, corporations, financial institutions, governments, etc.|
Conclusion: Usefulness of Forward Contracts
A Forward Contract may be beneficial for businesses and individuals when prices are volatile, and you want to lock in that rate to hedge against uncertainty in the future. This can be especially helpful for any business that wants to keep its cash flows predictable when buying or selling.