What are Forward Contracts and How Do They Work?

Traders use various strategies and financial instruments to maximise their returns and hedge risks. Trading in derivatives through forward contracts is one way by which hedgers can protect their portfolios, and speculators can seek to exploit more substantial returns. To understand the forward contract meaning, let us visit the following example.

Suppose you hire a cab to travel to your friend’s house. As you get into the cab, you and the cab driver agree on a specific trip payment. You agree upon the price before the actual trip even begins. You participated in a forward contract with the cab driver in this case. What is forward contract? How do these work? What is forward trading? Here is a detailed study on forward contracts.

What is a forward contract?

A forward contract is an agreement between two entities to sell or purchase an asset at a predetermined price on an agreed-upon date. Forward contracts derive their value from the underlying asset. As a result, there are various types of forward contracts that use different underlying assets such as currencies, stocks, commodities, etc. Moreover, these contracts are not regulated or traded on any exchange. As a result, forward contracts are considered over-the-counter (OTC) derivatives. One significant advantage of forward contracts is that they are customisable. Individuals can enter into tailored contracts to suit their requirements, which may serve numerous purposes compared to standardised futures contracts.

How Is Forward Trading Done?

The parties entering into a forward contract typically have opposing views on the future trend of the underlying asset. The buyer of the asset might believe prices will increase in the near future, while the seller might be of the view that asset prices may soon take a hit. Therefore, they negotiate a specific price for their future transaction, which they believe would be profitable. Forward trading can lead to multiple scenarios. Let us examine these in detail.

1. The underlying asset’s price increases -

   In this case, the buyer was right. Even though the prices increase, the buyer can purchase the asset at the predetermined price. The seller, however, experiences a loss. As prices increased, the seller would have made more substantial profits by selling the same asset for a higher price. However, by entering into the forward contract, the seller must fulfil the contract by selling sell the asset at the price determined in the forward contract.

2. The underlying asset price remains the same -

   If the buyer or seller were to make a transaction on the specific asset without the contract, the asset price would still be the same. Therefore, in this case, the buyer and seller each do not make any profit or loss.

3. The underlying asset’s price declines -

   In such a scenario, the seller makes a profit. Although the asset price falls, the buyer is still obligated to purchase the asset at the predetermined price, which would be higher than the current market price. Therefore, in this scenario, the buyer suffers a loss while the seller experiences a profit.

Example of Forward contract

Suppose you are the owner of a coffee shop and have become famous for serving great coffee. Your profits depend on the cost of coffee beans and the number of sales made by the shop. You make strategies to increase your sales. However, the price of coffee beans fluctuates. During peak season, the prices of coffee beans may spike considerably and eat into your profits. In such times, even though your sales are going great, you have muted profits. So you enter into a contract to purchase the coffee beans at a specific price irrespective of the price fluctuations. Whether the costs of coffee beans drop or spike, you pay a consistent amount for the coffee beans. Now, you can focus on increasing sales to expand your profits. The fluctuating prices of coffee beans are no longer a concern now. This is a forward contract example.

Features of a forward contract

Here are the critical features of forward contracts:

1. A forward contract involves only two parties, without the role of an intermediary. The buyer and seller directly enter into an agreement.
2. Forward contracts are customisable. These are not standardised contracts and are not traded on any Exchange.
3. The parties entering the contract have opposing views on the underlying asset price.
4. There are two ways by which the parties can settle the contract. The first is to take physical delivery, and the second is through a cash settlement.
5. Forward contracts do not require any margin amount and are easier to trade.

Conclusion

Traders use forward derivatives extensively to hedge against unfavourable price movements or by speculators to increase their profits. These are customisable contracts. However, since these are not regulated, the forward contracts may be subject to associated risks such as default and counterparty risk.