In the dynamic world of finance, various instruments and tools are employed to manage risk, hedge against uncertainties, and facilitate seamless business operations. One such instrument is the forward contract, a widely used financial agreement that enables parties to secure prices for future transactions, thereby mitigating potential market fluctuations. In this article, we will delve into the fundamental aspects of forward contracts.
What are forward contracts?
In the financial sector, a forward contract acts as a customised agreement between two parties. It details the purchase or sale of an asset at a predetermined price on a specific future date. These contracts offer flexibility for hedging. However, their non-standardised nature makes them especially well-suited for hedging strategies, allowing for tailored risk management against future price fluctuations.
Also read: What are options
Features of forward contract
Let us explore the key features of forward contract:
1. Non-standardised and over-the-counter (OTC):
Forward contracts are not standardised and are not traded on a stock exchange. This lack of standardisation allows the parties involved to customise the contract according to their specific needs, including the underlying assets, amount, and delivery date.
2. Customisable agreements:
Parties have the flexibility to make changes to the agreement, adjusting elements such as the underlying assets, quantity, and delivery date. This customisation feature makes forward contracts versatile and adaptable to the unique requirements of the contracting parties.
3. Settlement options:
Forward contracts offer two primary settlement options. Physical delivery involves the seller delivering the actual assets to the buyer, who, in turn, pays the agreed-upon amount. Alternatively, cash settlement occurs without the physical transfer of assets; instead, one party pays the other the appropriate cash differential to settle the contract.
4. Risk hedging for corporations:
Corporations commonly use forward contracts to mitigate and hedge against interest rate risk. This strategic use helps companies avoid the potential negative impact of purchasing assets at higher prices in the future, providing a mechanism for risk management.
5. No margin requirement:
Forward trading does not require margin, as it is not regulated by SEBI (Securities and Exchange Board of India). The absence of a margin requirement simplifies the trading process, making it more accessible and allowing for greater customisation in the absence of strict regulatory constraints.
Understanding forward contracts
This document outlines the key aspects and functionalities of forward contracts.
1. Components of a forward contract
- Underlying asset: The specific asset (commodity, currency, security, etc.) referenced in the agreement.
- Expiration date: The predetermined date on which the contract obligations are fulfilled.
- Quantity: The designated amount of the underlying asset to be bought or sold.
- Price: The pre-agreed price at which the asset will be exchanged on the expiration date, including the designated currency of payment.
2. Key characteristics
- Over-the-Counter (OTC): Forward contracts are customized agreements established directly between two parties, rather than being traded on a centralized exchange.
- Settlement: Upon expiration, the contract is settled by one party delivering the underlying asset and the other party making the agreed-upon payment and taking possession. Cash settlements, where only the price difference is exchanged, can also occur.
Applications of forward contracts
- Hedging: A primary function of forward contracts is to mitigate potential losses from price fluctuations. By locking in a future price, participants gain certainty in volatile markets. For instance, oil producers can use forwards to protect against falling oil prices.
- Currency exchange rate hedging: Forward contracts are employed to manage the risks associated with fluctuating currency exchange rates, particularly in international trade transactions.
Trading principle of a forward contract
The primary principle behind forward contracts is to lock in a future price today, regardless of market fluctuations. This can be especially valuable in volatile markets where prices can swing dramatically over short periods. By entering a forward contract, both parties commit to the agreed-upon terms, irrespective of how market conditions evolve. This can provide a sense of security and predictability in uncertain economic climates.
Mechanics of forward contracts
Learn about some mechanics of forwards contracts:
1. Contractual elements
A forward contract comprises essential components such as the underlying asset, contract size, price (also known as the forward price), delivery date, and the parties involved. The buyer agrees to purchase the asset at the predetermined price on the delivery date, while the seller commits to delivering the asset at the agreed-upon terms.
2. Price determination
The forward price is established when the contract is initiated. It is derived from the current spot price of the underlying asset and takes into account factors such as interest rates, carrying costs, and market expectations.
3. Non-standardisation
Unlike standardised financial instruments traded on exchanges, forward contracts offer flexibility in terms of contract specifications. This allows the parties to tailor the agreement according to their specific needs. However, this non-standardisation can also lead to challenges, as terms and conditions may vary significantly between different contracts.
4. Obligations and risk
While forward contracts provide a means of hedging against future price fluctuations, they also carry certain risks. If the market price deviates from the forward price, one party may benefit at the expense of the other. Additionally, the obligation to fulfill the contract on the agreed-upon date is binding, which could lead to unforeseen consequences if circumstances change..
Example of forward contract
Imagine a scenario where a farmer in India, let's call him Raj, cultivates a significant amount of wheat. Raj anticipates that the price of wheat might fluctuate by the time he harvests his crop in six months. He's concerned that a drop in wheat prices could negatively impact his income.
To address this concern, Raj decides to enter a forward contract with a local miller, Maya Flour Mills. The current spot price of wheat is Rs. 2,000 per quintal (100 kilograms). Raj expects to harvest 1,000 quintals of wheat in six months.
Raj and Maya Flour Mills negotiate a forward contract where Maya Flour Mills agrees to buy 1,000 quintals of wheat from Raj in six months at a forward price of Rs. 2,200 per quintal.
1. Potential outcomes of the above example
- Wheat prices increase: If the price of wheat rises to Rs. 2,500 per quintal in six months due to supply shortages or increased demand, Raj benefits from the forward contract. He can sell his wheat to Maya Flour Mills at the agreed-upon lower price of Rs. 2,200 per quintal. But Maya flour mill benefit more from this situation as it will be getting the wheat at a lower price because of the contract.
- Wheat prices decrease: If the price of wheat falls to Rs. 1,800 per quintal in six months due to a bumper crop or changing market conditions, Raj is still protected by the forward contract. He can sell his wheat to Maya Flour Mills at the higher forward price of Rs. 2,200 per quintal.
In both scenarios, Raj benefits from the forward contract by securing a fixed price for his wheat crop. The contract helps Raj manage the uncertainty of price fluctuations, providing him with financial stability and predictability for his agricultural income.
2. Considerations
- Counterparty risk: There's a risk that Maya Flour Mills might not honor the contract if they face financial difficulties. Raj needs to assess Maya Flour Mills' credibility before entering into the agreement.
- Opportunity cost: If wheat prices increase significantly beyond the forward price, Raj might miss out on potential higher profits by selling at the fixed forward price.
- Lock-in effect: The fixed price agreed upon in the forward contract might not align with prevailing market conditions. Raj might feel constrained if prices move more favourably for him after entering the contract.
Significance and applications
- Risk management: Forward contracts are widely used as risk management tools. Businesses that rely on commodities, such as farmers, manufacturers, and energy producers, can use forward contracts to hedge against price volatility and secure future revenues or costs.
- Currency management: Multinational corporations use forward contracts to manage currency risk. By locking in exchange rates in advance, they can safeguard against adverse fluctuations in foreign exchange rates when conducting international business transactions.
Difference between forward and future contract
While forward contracts and futures contracts may seem similar, there are some key differences that traders must understand.
1. Trading on exchange
Futures contracts are traded on organized exchanges, whereas forward contracts are traded over the counter (OTC) between two parties. In exchange-traded futures, the exchange acts as the counter party to both buyer and seller, and the exchange regulates the trades.
2. Standardised vs custom-made contracts
Futures contracts have specific details such as the contract size, deliverable dates, and terms, making it a more standardized contract. Forward contracts, on the other hand, can be customized to suit the needs of the parties involved, making it a more flexible contract based on the mutual understanding of both parties.
3. Counterparty risk
Futures contracts are backed by the exchange, so there is no counterparty risk involved. In contrast, forward contracts carry counterparty risk since the performance depends heavily on the financial stability of both parties involved, particularly true for a long-term forward contract or one with a large value.
4. Liquidity
Forward contracts have lower liquidity than futures contracts. This is because forward contracts are not traded on exchanges, while futures contracts are traded on exchanges. Exchange-traded contracts are more liquid because there are more buyers and sellers in the market.
Conclusion
In conclusion, forward contracts are an essential tool for investors and traders to hedge against price risks and market volatility. They offer flexibility and a customised approach to suit the unique needs of individuals and organisations involved. Traders worldwide use forward contracts for various reasons, including hedging, arbitrage opportunities, and income generation. It is essential to understand the nuances and variables of forward contracts while taking informed decisions. Lastly, it's recommended to work with a reliable and trustworthy financial service provider such as Bajaj Financial Securities to gain the correct insights and knowledge required to make the most out of forward contracts and maximise returns.
