What are Forward Contracts and How Do They Work?
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.
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.
Example Of a Forwards Contract
To understand the concept better, let us take a forward contract example. Let’s say a farmer is on track to harvest 20 tonnes of maize by next year. To make a profit on his harvest, he must sell it at a price of at least Rs 10,000 per tonne. 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 there is no saying what the price per tonne will be next year.
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 minimised. Therefore, even if the price of maize falls next year, he will be protected by the obligation of the forward contract and the fact that he will receive a higher price based on the lock-n price.
Features Of a Forwards Contract
Some of the most essential features of a Forwards contract includes:
- Unlike futures contracts, forwards contracts are not standardised and are not traded on exchanges. 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.
- The parties can settle forward derivatives in one of the two ways. One is where the seller makes physical delivery of the assets and receives the agreed-upon payment by the buyer. The other is where cash settlement occurs, and 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 minimise and hedge interest rate related risks. By entering into a forwards contract, they won’t have to purchase an asset at a higher price in the future.
- Forward trading typically requires no margin amount and is unregulated by the Securities and Exchange Board of India, i.e. SEBI, making it customisable and easier to trade.
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.