Forward Contracts Fast Becoming a Popular Investment Tool

Forward Contracts Fast Becoming a Popular Investment Tool

14 Nov 2018 04:26 PM

Definition: Forward Contract

With market scenario becoming highly volatile due to political uncertainty, increased levels of economic transactions and unpredictability of foreign currency trends, the forward contract has fast become a trusted financial instrument which is preferably used for hedging purposes as part of forex risk management strategy. This type of contract is basically an agreement between buyers and sellers. The sellers agree to offer a commodity at a specific price at a future date to the buyer.

There is another type of contract which an investor might confuse with the forward contract and this is known as a future contract. In the case of both forward and future contracts, the agreement to buy and sell an asset happens at a future date. However, even though the contract fundamentals may be the same, they both are distinct from each other because the specific details of these two contracts are very different. In the case of a forward contract, settlement takes place at the end of the contract. While in the case of a future contract it happens on a daily basis.

Similarly, investors in forward and the future contract can purchase or sell contracts at a specific time and price. Where future contracts are traded on exchanges which make it a standardized contract, in the case of forwarding contracts, it is more of a private agreement between counterparties to buy as well as sell an asset at a specified price in the future.  The essential features of it are-

  1. This type of contract is a bilateral contract.
  2. It is an over the counter contract.
  3. It is a custom designed contract and is unique as far as contract size, expiry date and in terms of asset type and the quantity of the underlying.
  4. Settlements take place on a specific date in future at a price that is agreed today thereby making it a derivative instrument. The price agreed upon is known as the delivery price.

This instrument is one of the many forms to buy or sell orders where the time and the date of the trade are not the same as is the value date and securities themselves are therefore exchanged. Here, the counterparties involved agree upon buying the underlying asset in the future assuming a long position and the party agreeing to sell the asset in the future assuming a short position.

The utility of Forward Contracts Tool

Primarily the forward contract is used by exporters and importers to ‘hedge’ their foreign currency payables and receivables so as to cut down the volatility of an asset’s price. As the terms of the agreement are set when the contract is executed that is why price fluctuations does not affect forward contract. Now take for instance, when two parties agree upon the sale of 1000 ears of corn at $ 1 each, do you think the terms can change in the midway even if the price of corn goes down to 50 cents per ear? The answer to it is ‘No’.

The nature of forward contracts is such that it is readily available to retail investors. The market for forward contracts is often hard to predict and that is due to the nature of the agreements and their details are generally kept between the buyer and seller and are not disclosed among the public. Further, because these agreements are private, there is a high amount of counterparty risks involved, implying that one party will default. In India, with exporters and importers mainly being one of the parties of the forward contract, the counter parties are generally the financial institutions like public and private banks.

However, with foreign currency fluctuations becoming so rampant in the present time, entering into a contract where the underlying can be purchased and sold at a predetermined rate in the future seems to at least ensure the input cost and reasonable amount of profit to the investor. Again, if the future rate is lower than the spot rate and involves monetary outflow or purchase, in that case, traders can incur an opportunity loss. But in order to cover probable loss which might arise in the course of execution, this type of contract still holds much value to manage the market risks or even credit risks involved in the process.

A forward contract refers to an agreement between the two parties i.e. buyer and seller of an asset wherein they set the price at a point of time in zfuture. There are various assets that are traded in such contracts like grain, metals, oil etc. Even financial instruments are traded in such contracts. It is a customized contract that is usually used to hedge or speculate the risk that is generally involved with respect to the dealing in foreign currency at a future date. It can be customized according to the commodity, amount and delivery date. These contracts can be settled on a cash or delivery basis. They are not traded on a centralized exchange and hence are regarded as over the counter instruments. The party that agrees to buy the asset in the future assumes a long position and the party agreeing to sell the asset assumes a short position. The price agreed is known as the delivery price or forward price.

Time and date of trade might or might not be same as value date i.e. when the securities are exchanged. Forwards like other derivative securities are mostly used to hedge currency or exchange rate risks.

How Forward Contracts differ from Future Contracts

A forward contract is often confused with a future contract. The two terms might seem to be similar but are actually different in certain aspects. Both forward and futures contract allow people in trading of an asset for a specific time duration at a given price. However, both of them differ in certain aspects. Settlement is different in case of both the contracts. Settlement in case of a forward contract occurs at the end however future contracts settle every single day i.e. both the buyer and seller are required to have money to deal with every day fluctuations in price for the entire life of the contract. The parties in a forward contract bear more risk than that in case of a futures contract as the risk of default is more in prior. Forward contract prices often include premiums for the added credit risk.

Forward contracts, unlike futures are not exchange traded and hence are not standardized assets. Also, in most cases they do not have interim partial settlements in margin requirements which usually happens in case of a future contract. Forward contracts as mentioned earlier are traded over the counter and hence specifications can be customized and may include mark-to-market and daily margin calls. The terms for a forward contract usually decide the collateral calls based upon certain events that are relevant like credit ratings, value of assets etc.

Relevance of Forward Contracts

There are two kinds of participants in case of forward contract. One being hedgers and the other being speculators. Hedgers usually do not target profit but seek to stabilize the costs or revenues of the operations of their business. Their gains or losses are mostly nonexistent, a profit or loss is usually nullified by the loss or profit in the market for the asset being traded. On the other hand, Speculators are not really interested in taking the possession of the asset, they place bets on the direction of prices of the asset in the market and play on predictions. Speculators mainly target to make profit from dealing. Forward contracts usually seem more attractive to hedgers than ton speculators.

Valuing Forward Contracts

The value of a forward contract varies with the value of the asset being traded in the market or the underlying asset.Forward contracts are often referred to as zero sum games I.e. if one party makes a profit of 200 dollars the other party incurs a loss of the same amount. A forward contract can be cash settled i.e. they can make a single payment for the value of forward contract. For instance: if the price of 400 bushels of wheat is 1000 dollars in the spot market when the forward contract expires hover the contract requires the buyer of wheat to make a payment of 900 dollars, in this case the seller of wheat can settle the forward contract by making a payment of 100 dollars.

When the price in the spot market is higher than the price in the forward contract, it is known as backwardation. On the other hand, when the price in the spot market is lower than the forward contract price it is known as contango.

One must consider the fact that there is a risk of price manipulation in case of a forward contract because if a small transaction completed at a price below the market price or above market price it could impact the value of a larger forward contract.

How do Hedgers Calculate the Forward Rate?

In the trade, the demand and supply of goods and services are important variables that determine the rates of a particular currency. In a free-floating exchange rate system, the exchange rates are mainly determined by the demand and supply forces. The supply and demand, in turn, are influenced by a number of macroeconomic factors such like interest rates, inflation, the growth rate of GDP, monetary and fiscal policies, the balance of payment situation and many other factors. Out of all these factors, inflation and interest rates are considered to be the most important factors to determine the forward rate.

The forward exchange rate is ‘determined by a parity relationship among the spot exchange rate and differences in interest rates between two countries.’

Quick Advantages of forwarding Contract

  1. Gives the businesses certainty over the exchange rate irrespective of the prevailing spot rate on maturity.
  2. Helps a business protect its profit margins from foreign currency market downside.

In India, the forward contract is mainly applied for hedging purpose. Exporters and importers hedge not always with the intent to seek a profit but to gain stability in the revenue or cost of their business operations. The gains or losses are generally offset to some degree by a corresponding gain or loss in the underlying market for the underlying asset. Unlike hedgers, speculators however, do not make use of the underlying assets. They mainly go with the flow of placing bets on which prices will go.

Forward contract’s value changes with the change in the value of underlying asset. Also, if the underlying exposure (payable/receivable) which initiated the forward contract gets cancelled, extended or even preponed, in that case, the forward contract is cancelled, extended or delivered at the earliest.

In such cases, the concept of rollover contract comes at play wherein the expected foreign exchange inflow or outflow is delayed for business reasons and the underlying is still in place. In such cases, the future contract is rolled over to further future maturity date. Early utilization of forward contracts is done when the realisation of the foreign currency happens before the forward contract booked date.

Over a period of time, the forward contract is fast gaining prominence in the economy. This is mainly because it is helping corporates and investors to safeguard their exposure from both domestic and foreign exposure. It is fast becoming a safe mode of investment too.

Read more about Fx risk management

Recommended for you...