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 Contracts. 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.
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