17.3 Forward contracts
Before discussing this concept lets discuss about spot market. In a spot market, what you generally do? You go to market and agree on price and settle the deal right? The spot market or cash market is a commodities or securities market in which goods are sold for cash and delivered immediately. Contracts bought and sold on these markets are immediately effective. Suppose Mr. Mahesh wants gold and he approaches Ramesh who is a gold trader- they agree on a price and gold is given to Mahesh in exchange for Cash. It is simple and we can say it is a spot market trade. On the other hand, in a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon. It is a contract to be undertaken in a future date.
So in a forward contract there is an agreement
- Agreement is to buy or sell the underlying asset.
- The transaction takes place on a predetermined future date.
- The price at which the transaction will take place is also predetermined.
Suppose a buyer Mahesh and a seller Ramesh agree to do a trade in 100 grams of gold on 31 Dec 2010 at Rs.160, 000. Here, Rs.160, 000 is the “forward price of 31 Dec 2010 Gold” it is a forward contract. As per the derivative terminology, the buyer Mahesh is said to be in long position and the seller Ramesh is said to be short position. Once the contract has been entered into, Mahesh is obligated to pay Ramesh Rs. 160,000 on 31 Dec 2010, and take delivery of 100 grams of gold.
Similarly, Ramesh is obligated to be ready to accept Rs.160, 000 on 31 Dec 2010, and give 100 grams of gold in exchange. One pre-requisite of a forward contract is that there should be another party which is willing to take a reverse position. For example, in the above case we may sell gold forward only if someone is willing to buy it in Dec 2010. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.
The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The concept of forward contracts are explained in detail in our commodity market section.
Settlement of forward contracts
When a contract expires, there are two alternate arrangements possible to settle the obligation of the parties, physical settlement and cash settlement. Both types of settlements happen on the expiry date and are given below.
A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date.
Cash settlement does not involve actual delivery or receipt of the security. Each party either pays (receives) cash equal to the net loss (profit) arising out of their respective position in the contract.
Terminology to Ponder
Long Position: The party who agrees to buy in the future is said to hold long position. For example, in earlier case Mahesh has a long position.
Short Position: The party who agrees to sell in the future holds a short position in the contract. In the previous example Ramesh has a short position.
The Underlying Asset: Means any asset in the form of commodity, security or currency. in our example it is gold.
The Forward Price: Means the agreed upon price at which the counter parties will transact when the contract expires. In our example Rs. 160,000/100 grams is the forward price.
Limitations of forward markets
Forward markets world-wide are affected by several problems:
- Lack of centralisation of trading.
- Counterparty risk.
Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaults between the initial agreement date and delivery date, you may have a loss. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.