Tuesday, 12 January 2016

What are Forward Contracts

What are forward contracts?

 A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupee-dollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants.
The main features of a forward contract are:

·        It is a negotiated contract between two parties and hence exposed to counter party risk. eg: Trade takes place between A&B@ 100 to buy & sell x commodity. After 1 month it is trading at Rs.120. If A was he buyer he would gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter party Risk i.e. You will now entitled to your gains. In case of Future, the exchange gives a counter guarantee even if the counter party defaults you will receive Rs.20/- as a gain.

·        Each contract is custom designed and hence unique in terms of contract size,expiration date, asset type, asset quality etc.
·        A contract has to be settled in delivery or cash on expiration date as agreed upon at the time of entering into the contract.
·        In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.