What is a forward contract?
Is it really possible to buy an asset now at a fixed price to be paid at a fixed time in the future? Well, it is possible with the help of a forward contract. A forward contract forms the basis of the derivates world, which is primarily used as a hedge against various risk exposures.
Definition and meaning
A forward contract is a commitment in the form of a contract that provides the ability to lock in a price or rate, at which, one can buy or sell the underlying assets at a certain future date. A forward contract has been further standardised and modified as what we know as ‘futures’ in the stock market.
Let us understand the concept with the help of an example:
ABC is expecting to harvest the produce of 100 kg of wheat in 30 days from today. The current rate in the market is Rs 50 per kg. For some reason, ABC expects the prices to go down 30 days from now. And if that happens, his profits will naturally decrease. He discusses this concern with a crop trader XYZ. Being a trader, he makes an offer to ABC. Let us say, XYZ agrees to buy his yield at a fixed price of Rs 45 after 30 days. Here, XYZ is expecting the price of wheat to go up in the future. ABC happily enters into the contract, as his uncertainty and risk have been reduced. He will receive a total of Rs 4,500 (45*100) after 30 days, irrespective of market prices. Let us say after 30 days, the market price of wheat goes down to Rs 40 per kg. Here, the trader XYZ suffers a loss of Rs 500 (5*100). However, the farmer ABC is happy since he is selling his yield at Rs 45 i.e. Rs 5 more than the market rate. With a bird’s eye view, this is how a forward contract works.
In the above case study, the underlying asset was wheat. What we usually see in the finance world, the underlying asset is usually bonds, interest rates, etc. Two parties come together and make an agreement and so, it is a customised contract. It is also referred to as over-the-counter (OTC) product. Unlike the above example, the notional amount, i.e. Rs 4,500 in the above case, is not transferred. Only the profit money is received, which is also called forward value. The forward price is the price at which the future transaction is fixed (in the above case, it’s Rs 45). One party gains at the expense of the other. It is a zero-sum game. It is true that it reduces the risk for the parties but does not completely eliminate it. Even though the price risk is hedged, counterparty risk is prevalent. XYZ can simply deny buying from ABC. Considering all these factors, futures are developed, which we will study in another knowledge article. Stay tuned for that!