Forward Contract- Important Features and How does it work?

Forward Contract- Important Features and How does it work?

01 Aug 2019 05:35 PM
 

What is Forward contract?

A forward contract entails a type of foreign currency transaction wherein the agreement attained between two parties regarding the exchange of two designated currencies at a specific time in the future extends added security to the buyer from fluctuations in currency prices since the contracts materialize after the date that the spot contract settles.

It is put together between two parties and can be customized according to the required guidelines for the purpose of buying and selling an asset at a specified price on a future date. This contact has a non-standardized nature which makes it suitable for the purpose of hedging, but it can also be used for speculation purposes. In this forward contract, the company which is agreeing for the purchase of underlying assets in future times is assumed for the long position, and the company which is involved in the selling of the assets in the future time is assumed for the short position. The price upon which both the companies agree in the forward exchange contract is termed as Delivery Price, which is equal to the forward price at the time the contract is entered into. Forward market hedging is a mechanism employed to enable protection from forex exposures. Currency hedging in lay man's terms is the act of entering into a financial contract in order to safeguard unexpected, expected or anticipated changes in currency exchange rates. The cancellation of the forward contract requires the obtainment of consent from both the parties involved and safeguards them by eliminating the risk arising from unexpected or adverse movements in the currencies' future spot rates. For most currency pairs forward exchange rates can be obtained for up to 12 months in the future whereas for the four pairs of currencies - USDINR, GBPINR, EURINR and JPYINR known as the "major pairs" up to 10 years of exchange rates can be obtained.

Basic understanding of a Forward Contract

A forward contract allows customization as per the understanding of both parties that settles at the end of the agreement, which is unlikely to be achieved in case of future contracts with standardized terms traded on an exchange wherein settlement of prices happen on a daily basis until the end of the contract.  Trading of various commodities can be done through a forward contract like natural gas, oil, grains, various types of precious metals, and it can occur on a cash or delivery basis. Forward exchange contract is also termed as over-the-counter (OTC) instruments as they are not traded on a centralized exchange. In the forward contract, the seller has the ability to lock in the pricing for a particular asset which can be counted in as a major advantage of a forward contract, as this helps in managing the risk by ensuring that you're able to sell the asset at a target price of your choosing. Forward contracts are implementable for minimizing the volatility of an asset's price and are known to be applied by many hedgers as a risk-mitigating mechanism. It is not subjected to market fluctuations owing to its nature wherein the terms of the agreement are set when the contract is executed. However forwards are not readily available to retail investors which makes the market of the forward contracts unpredictable and uncertain as the agreement details are generally kept between the buyer and seller, and are not made public but run a counterparty risk owing to private agreements. A forward market hedge involves the use of foreign exchange forwards and consists of outright purchase of currency at a forward exchange rate. The spot exchange rate and interest rates in the two countries whose currencies are involved influence a forward market hedge

The risk associated with a Forward Contract

The forward contract market witnesses wide spectra of participation from the world’s biggest corporations that use it for currency hedging and interest rate risks. However, the problem arises as the details of the respective contracts are only acknowledged by the buyer and the seller fostering a veil of obscurity for the general public which creates a difficulty in estimating the market. These contacts are prone to a cascading series of defaults in the worst-case scenario, because of its large and unregulated nature. Though banks and financial corporations take an extended caution by being extremely careful in their counterparty choice, the possibility of large-scale default persists. Another complication associated with a forward contract because of its non-standardized nature is that they are only settled on the settlement date and are not marked-to-market like futures. What will happen if the forward rate specified in the contract divaricate from the spot rate at the time of settlement? In this case, it makes the financial institution that originated the forward contract exposed to a much greater degree of risk in the event of default or non-settlement by the client vis-A -vis if the contract were marked-to-market regularly.

How does Forward Contract work?

A currency forward contract locks the exchange rate for a currency's purchase or sale at a future date and serves as a hedging instrument with no upfront payments. The constituent binding agreement of the forward contract can't be broken when one party stands to lose. Suppose company X located in the United States company plans to sell 1,000 computers to a Canadian company wherein the price of each computer to be sold is determined  500 Canadian dollars. As the exchange rate is 1.1 U.S. dollars to 1 Canadian dollar, the amount expected to be received by company X comes to be 500,000 Canadian dollars which upon currency exchange amounts to 550,000 U.S. dollars. Due to uncertainty of the market company X  is worried that the exchange rate may move to 1.05 U.S. dollars to 1 Canadian dollar before the sale of computers is completed which will yield a lesser revenue of 525,000 U.S. dollars. To navigate the uncertainty and ensure that their profits are not highly affected company X  enters a currency forward contract with a bank offering a 6-month forward rate of 1.08 U.S. dollars to 1 Canadian dollar. Upon realisation of the deal company X receives 500,000 Canadian dollars as planned and gives it to the bank to receive the exchange for 540,000 U.S. dollars as per the terms of their contract. Here company X has employed forward contract for hedging forex to minimise their losses due to forex exposures. There are profoundly two ways for a settlement to occur in a forward contract: delivery basis or cash basis. The seller is bound to transfer the underlying asset or assets to the respective buyer if the contract is on a delivery basis. After that, the buyer pays the seller with cash on the contract's price. The buyer still has to pay the agreed settlement date with a cash amount, but no assets change hands. This payment amount is determined by the difference between the current spot price and the forward price.

How can Myforexeye Forex Risk Advisors Help Businesses?

Myforexeye, Risk Management service, consists of four packages which are Starter, Standard, Premium and Enterprise each bearing different facilities but collectively aimed towards dispensing professional advice regularly for mitigating risks associated with forex market transactions and forex trading.

Forex advisory consists of strategies, techniques like hedging forex and analyses that steadfast companies against forex exchange exposures and safeguard them from potential risks like financial, political and country risk. The forex advisory service of Myforexeye establishes its credibility and efficaciousness through the implementation of an approach that is centred around protecting business budgets and managing risks rather than speculating on forex. The Forex Current Account enhances the scale of your business by allowing cross border forex transactions along with the availability of real-time forex rates that fortifies your understanding of the value that one can expect upon payment associated with overseas trade upon the determined period of deal maturity. Our service renders one capable of accessing exchange rates up to one year to aid decisions related to international trade through a Forward rate calculator.

Conclusion

Myforexeye is the one-stop solution for all the forex needs of organizations irrespective of their scale and individual forex enthusiasts wherein our services discharged are powered by advanced technology, armed with the expertise of experienced professionals and executed by our specialized team. Our user-friendly platforms- web portal and mobile app encourage actualization of our objective of providing a transparent streamlined process which meets the forex demands of users in a convenient manner eliminating the aspect of hidden commissions. Our consultants help users manoeuvre challenges and risks associated with the forex market and render strategies and techniques to mitigate them. Enabled by our lack of obscurity, our services empower users to make savings corroborated by our platform that provides an insight into real-time rates and best quotations from banks to equip you with the best possible options. 

Speak to one of our specialists to acquire a detailed understanding of Forward Contracts and the array of Myforexeye forex services.

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