Financial derivative types: Forward Contracts

Forward contracts: Forwards are the oldest of all the derivatives. Forwards are contracts to buy or sell an asset on or before a future date at a price specified today or an agreement between two parties to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc. Eg: On January 1, Mr. X enters into an agreement to buy 5 sacks of basmati rice on June 1 at Rs. 3000/- per sack from Mr. Y, a wholesaler. It is a case of a forward contract where Mr. X has to pay Rs. 15,000/- on June 1 to Mr. Y and Mr. Y has to supply 5 sacks of basmati rice.

In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date said to be in the ‘Long position’. On the other hand, the user (holder) who promises to sell at an agreed price at a future date is said to be in ‘Short position’. Thus, ‘long position, and ‘short position, take the form of ‘buy’ and ‘sell’ in a forward contract.

Features of forward contracts:

In a forward contract, the supply of an asset is promised at a future date. This contract is usually referred to as ‘Forward Rate Contract’ (FRC). The main features of forward contracts are:

  • Over the Counter Trading (OTC): These contracts are purely privately arranged agreements and hence, they are not at all standardized ones. They are traded ‘over the counter’ and not in exchanges. There is much flexibility since the contract can be modified according to the requirements of the parties to the contract. Parties enter into this kind of contract on the basis of the custom, and hence, it is also called ‘customised contract’. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.
  • No Down Payment: There must be a promise to supply or receive a specified asset at an agreed price at a future date. The contracting parties need not pay any down payment at the time of agreement.
  • Settlement at Maturity: The important feature of a forward contract is that no money or commodity changes hand when the contract is signed. Invariably, it takes place on the date of maturity only as given in the contract.
  • Linearity: Another special feature of a forward rate contract is linearity. It means symmetrical gains or losses due to price fluctuation of the underlying asset. When the spot price in future exceeds the contract price, the forward buyer stands to gain. The gain will be equal to spot price minus contract price. If the spot price in future falls below the contract price, he incurs a loss. The gain which one get when the price moves in one direction will be exactly equal to the loss when the price moves in the other direction by the same amount. It means that the loss of the forward buyer is the gain of the forward seller and vive versa.
  • No Secondary Market: A forward rate contract is a purely private contract, and hence, it cannot be traded on an organized stock exchange. So, there is no secondary market for it.
  • Necessity of a Third Party: There is a need for an intermediary to enable the parties to enter into a forward rate contract. This intermediary may be any financial institution like bank or any other third party.
  • Delivery: The delivery of the asset which is the subject matter of the contract is essential on the date of the maturity of the contract.

Financial forwards:

Forward rate contracts for commodities are commonly found in India. But, the use of this instrument in the financial markets is a new phenomenon. The popular type of financial forward rate is the forward rate currency contract.

Forward Rate Currency Contract: It is a contract where exchange of currencies is promised at an agreed exchange rate at a specified future date. The important feature of this contract is that the payoff is proportional to the difference between the rate specified in the Forward Rate Contract and the price of the currency prevailing in the market at the time of settlement.

Forward Rate Contract on Interest Rate: The extension of the forwards to the interest market is an important innovation. This type of contract is called Forward Rate Agreement (FRA). It is a contract where parties enter into a forward interest rate agreement at a specified future date. On the date of maturity, the difference between the forward interest rate as mentioned in the agreement and the interest rate prevailing in the market at that time (Spot rate) is paid / received (as the case may be) on a notional principal. The special feature of this contract is that the holder or user of this forward is protected against future rise in interest rates. It is so because, on the due date, the interest which he has to pay will be exactly equal to the Forward Rate Agreement rate. For example, a financial intermediary expects a good demand for funds after 4 months. So, he enters into a Forward Rate Agreement after 4 months at a specified interest rate. After 4months, he has to pay or receive the difference between the FRA interest rate and the market interest rate. As a result, his net payment of interest on the funds borrowed after 4 months will be equal to the FRA rate only.

This type of agreement is confined to short period only and due to risk of default, long dated forward rate contracts are not popular. Thus, forwards are becoming popular in markets in recent times.

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