What is a Forward Contract? Know the meaning, forward contract examples and learn how forward contracts are settled. How they are used? What are the potential risks involved in Forward contracts?
Let’s unfold the answers to these queries one by one…
Derivatives are considered one of the most complex instruments in finance. But they’re not, in fact understanding the idea of derivatives is only limited to actually trying to understand it. Once you do, they are one of the most useful instruments in trading or general investing. They’re sort of like that friend whom you thought is a mean individual, but then you got to know them and realized how you’re a judgmental and terrible human being.
And derivatives also make you money, so that’s nice. Derivatives like options, forwards and futures are called derivatives because they ‘derive’ their value from another asset, the underlying security, get it? No? Well then, let’s get into it.
What is Forward Contract? Meaning
Forward Contracts do exactly as the name suggests. They are contracts made today regarding purchase or sell of an underlying asset, but executed at a later date in future, but with the price that is fixed today in the contract. A forward contract has both right and an obligation to be executed.
Forward Contract: Example
It works a little something like this. Say you have a car that you want to sell. Now you find a buyer, Mr. A, that agrees to buy it at Rs. 1 lakh, but a month later. You know the basic rule of assets like car, the longer they’re out of the showroom, the lesser resale value you’ll get. So you agree, but to cover your bases, you ask for a contract for that agreement. Mr. A agrees.
Here, you could also say that you, the seller, are expecting the price to go down, which for you is a short position. Mr. A is expecting that you may get a better price between now and a month, a long position.
Then Mr. A leaves and you’re wondering to yourself what kind of parents name their child after the first letter of the alphabet, the sheer lack of effort. Later, Mr. A then talks to his younger brother, Mr. B, who likes the car and the price in which Mr. A has managed to lock in the contract. He asks Mr. A to sell that contract to him at a premium, and since this is a hypothetical, Mr. A agrees. Then they go back to arguing on whose child gets to be named C.
Now when the month ends, Mr. B comes to you with the contract and asks to buy the car. And you don’t mind because you’re still getting the price. But here’s where it gets interesting. Even if the price of that car had fallen drastically during that month, Mr. B would still have to buy at the agreed upon strike price. Same holds true to if the price had risen, and Mr. B would have made a profit.
In both cases, you would have to sell it to Mr. B and he has to buy, unless both of you agree not to exercise the contract, which is a Contract Law thing, not really related to forwards. Also, it does not mean Mr. B has to buy the car if you show him the car wrecked and rolled up in a metal ball with wheels, again a Contract Law thing, you get it.
You may also like: Stock Market Basics for Beginners
How are Forward Contracts Settled?
Forward Contracts are settled in one of the two ways:
1. Delivery-Based Settlement:
This one is simple. You ‘deliver’ the asset, get your money, and then go back to your house and cook marshmallows and have hot cocoa. Last part optional. But marshmallows are awesome.
2. Cash-Based Settlement:
This one is also simple, but this is ‘pay the difference’ kind of approach. Suppose the market price of the car falls to Rs. 80000. Here, Mr. B may not want to buy the car, for ample of different reasons. But because it’s a contract, you are entitled to your Rs. 1 lakh. So, Mr. B asks you to sell the car in the market for Rs. 80000, and he will pay the difference of Rs. 20000 to you.
Forward contracts are the simplest form of derivatives, but due to several reasons, they’re also one of the least popular type of contracts among derivatives, especially when compared to Options, which basically are forward contracts without the obligation.
This is majorly due to the disadvantages or risks associated with Forward Contracts.
What are the Risks related to Forward Contracts?
The first risk originates from the property of not having a Clearing House between the parties, which is the default risk. This means because there is no authority to enforce the transaction between the parties, and keep stuff as guarantee, there is a huge risk of re-engaging between parties involved. The over-the-counter nature of this market also makes it impossible to judge the market size.
Also, there is the general market risks to both sides. If the price of the underlying asset goes up, the seller loses money. If the price goes down, the buyer loses money.
How are Forward Contracts used?
Everywhere. As mentioned earlier, all the other derivatives stem out from forward contracts. But Forward contracts as an instrument are mainly used by Banks, Hedge Funds and Institutional Investors, mainly for hedging purposes and currency trading.
Consider this, Your country provides you interest at 10%, in INR. Country B provides 20%, in USD. Hypothetically, say at time of purchase, 1 USD = 70 INR. But you know the price keeps fluctuating, and it might happen that the INR may worsen against USD and you end up losing money even after interest earned. So you hedge your transaction using a forward contract, by agreeing to exchange your USD after a year of earning interest at 70 INR. Even if the price goes up, but especially if the price goes down. So, worst case scenario, you get your money back after earning 20% interest at the current rate i.e Rs. 70.
This process, in the biz world is called covered interest arbitrage, which, to be honest, is a complicated name for something really simple.
The Bottom Line
Forwards are to derivatives what Hasan Minhaj is to news-comedy; original, simple and informative, but still, Jimmy Fallon is more popular, so….
For the two of you that get the joke, accurate right? Just trying to serve all kinds of audience here, covering all the bases, you know. Comment! Let us know what you think. And go have some marshmallows with hot cocoa, and enjoy!
Disclaimer: There is a high degree of risk involved in stock trading and investing in any risky asset classes. The details given on this website are for informational purpose only and cannot be constituted as professional advice in any regard. Please follow due diligence while investing your money.
And yes, don’t forget to share your valuable opinions on Forward Contracts or any other form of derivatives. Your experiences can help others take smart investing decisions.