Forward Contract: Features, functionality and examples

Derivatives are financial contracts made between two or more parties that derive their value from an underlying asset. They are typically used to hedge an option, give leverage to holdings or speculate on the directional movement of an underlying asset. A forward contract is a derivative instrument that aids in mitigating risks while trading. In this article, we will look at what is forward contract, its functionality, features and types to get a thorough understanding of this financial instrument. 

What is a forward contract?

A forward contract refers to a contract made by two parties to purchase or sell an underlying asset at a fixed price on a particular date in the future. The term forward is used because the contract is made for a transaction in the future. 

The value of the forward contract is determined based on the value of the underlying assets such as currencies, commodities or stocks and so the forward contract acts as a derivative. 

The forward contract differs from the options contract in that both parties in this contract are obligated to execute the transaction and take delivery of the underlying asset. The forward contract is an over-the-counter derivative since they are not traded on a centralised exchange. 

The two types of forward contracts are fixed-date forward contracts and option forward contracts. 

Additionally, another thing to keep in mind is that the forward contracts are negotiated privately, without an intermediary which is why they are relatively more customisable compared to standard derivatives contracts. 

How does forward trading work? 

Two parties enter a forward contract because of their opposing views on the underlying asset’s future price. The first party, the buyer, believes that the price of the underlying asset will rise in the future and therefore agrees to purchase it at a predetermined price to make profits based on the price difference. 

The other party, the seller, believes the contrary that the price of the underlying asset will fall shortly and they desire to cut down losses by locking in at a predetermined price. Now based on the market performance and price fluctuations, there can be three scenarios: 

The price of the underlying asset rises

In this scenario, the buyer’s prediction comes true and they can sell the underlying asset at a higher value. The delivery of the underlying asset is executed by paying the lower predetermined price in the contract and selling it in the open market. 

The profit of the buyer equals the difference between the current underlying asset value and the locked-in price at which the buyer purchased it. 

The pierce of the underlying asset falls

In this scenario, the seller’s prediction comes true and they benefit from the sale made via the forward contract. Even though the price of the underlying asset has fallen, the seller can sell it at a higher price than its current value. 

The profit of the seller equals the difference between the actual price of the underlying asset and the price at which the seller sells it. 

The price of the underlying asset remains unchanged

In this scenario, the prediction made by neither of the parties comes true and hence, there is a no profit no loss situation for both the parties. 

Forward contract example 

Let us better understand the concept by considering a forward contract example: 

Imagine a situation where an airline company is concerned about the potential price rise in the oil market. 

They calculate the amount of Aviation Turbine Fuel they would require after 6 months. 

On the other side, there is an oil producer who wants to secure a buyer to sell its oil production in the future. This is where they enter into a forward contract for 1,000 kilolitres of aviation fuel at INR 1 lakh per kilolitre to be purchased 6 months from now. 

If after 6 months the price of the aviation fuel rises to INR 1.20 lakhs per kilolitre then the airline company still gets to purchase the fuel at INR 1 lakh because they locked in a price lower than the market price. 

As against this, if the airline price falls to INR 80,000 per kilolitre then the oil company benefits as the sale will still be made at INR 1 lakh. 

Features of forward contract

The  core features of forward contract include: 

Easy to trade

There is no margin amount requirement in the forward contract and hence, they are more flexible and easy to trade without the SEBI governance. 

Hedge risks

Forward contracts are commonly used by companies to hedge interest rate-related risks. These contracts ensure that companies do not have to purchase an asset at a high price in the future. 

Two ways of settlement

The forward contract can be settled in two ways. One way is where the seller executes a physical delivery of the underlying asset and gets the fixed payment. The other case is of cash settlement where one party pays the others an appropriate differential in cash and no physical delivery of the underlying asset is made.

Forward contract vs future contract

Let us also understand the difference between forward and future contracts to understand the two better. Both these contracts are concerned with selling and buying a commodity in the future at a fixed price. 

However, while the forward contract does not trade on an exchange, a futures contract is traded on an exchange. Additionally, the settlement of the forward contract takes place at the end of the contract while that of a futures contract happens daily. 

Lastly, future contracts are standardized contracts that cannot be customised between counterparties while forward contracts can. 

Conclusion 

A forward contract is an excellent tool to ensure a safety net for both buyers and sellers based on their anticipated future asset prices. It helps minimize risks in several cases. However, before entering a trade, it is integral to fully understand the risks associated with a forward contract and study its negatives in case the market conditions are not favourable. To understand more such financial concepts, stay tuned to StockGro. 

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