You must have heard about futures and Options contracts in the stock market, but many people don’t know what is a forward contract. This type of contract is completely different from Future contacts. Let’s discuss the meaning of forward contact with examples and the difference between future and forward contract.
Table of Contents
What is a forward contract?
The forward contract definition is a specific agreement between two entities to purchase or sell an instrument at a predetermined price at a later period. A forward contract can be used for hedging or speculation, however because of its non-standardized character, it’s best for hedging.
Forward contracts can be personalized to a particular product, quantity, and delivery date. Forward contracts are classified over-the-counter (OTC) transactions because they are not traded on a centralised exchange.
When compared to contracts that are marked-to-market on a regular basis, financial institutions who begin forward contracts have a higher level of settlement and default exposure.
Example of Forward Contract Meaning
After knowing forward contract meaning, let’s understand it with the preceding forward contract scenario. Suppose an agricultural producer has 2 million bushels of corn to sell in 6 months and is worried regarding a possible drop in corn prices.
As a result, it engages into a forward contract with its financial institution to sell 2 million bushels of corn for INR 5.60 per bushel in six months, with a cash settlement.
Possibilities
- The price per bushel is exactly the same at INR 5.60. The producer and the financial institution owe each other no money in this situation, and the contract is closed.
- It is more expensive than the contract price, which is around INR 6 per bushel. The gap between the current spot price and the agreed rate of INR 5.60 owes the producer INR 0.8 million to the institution.
- It’s less than the contract price of INR 4.80 per bushel, for illustration. The producer will receive INR 1.6 million from the financial institution, which is the difference between the negotiated rate of INR 5.60 and the actual spot price.
Types of Forward Contracts
There are majorly seven types of Forward contract existing in the market. These are:
- Window Forwards
- Long-Dated Forwards
- Non-Deliverable Forwards (NDFs)
- Flexible Forward
- Closed Outright Forward
- Fixed Date Forward Contracts
- Option Forward Contract
How it works
Forward contracts can enable local farmers and clients to hedge against price changes in the actual asset or commodity. A forward contract, unlike a typical futures contract, can be personalized to a specific commodity, quantity, and delivery date.
Grain, precious metals, natural gas, oil, and even poultry are examples of commodities exchanged. A forward contract might be settled in cash or in the form of a delivery.
Forward contracts are considered over-the-counter (OTC) securities because they are not traded on a centralised exchange.
While the lack of a stock exchange house makes it easier to modify terms, the lack of a centralised stock exchange also increases the possibility of default.
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Note
Forward contracts are not as accessible to retail investors as futures contracts due to the risk of default and the lack of a centralised exchange.
Features of Forward Contract
Let’s look at some of the most important elements of forward contracts now that you understand types of forward contracts better:
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Similar characteristics
Forward contracts and future contracts have a number of the same characteristics. When trading derivatives, though, it’s important to keep a couple of their significant peculiarities in mind.
Forward contracts, unlike futures contracts, are not traded on exchanges. As a result, they are more adaptable, allowing for particular adjustments in the agreements in terms of the item transferred, the amount, and the delivery date.
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Settlements
The majority of forward derivatives can be paid in one of two ways.
They can either result in a physical settlement, in which the seller physically delivers the assets and receives the agreed-upon money from the buyer, or they can result in a financial settlement, in which the seller receives the agreed-upon payment from the buyer.
Alternatively, they can result in a financial settlement in which the asset in question is not physically delivered. Rather, one of the two parties closes the contract by paying the other a monetary equivalent of the difference.
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Use
Forward contracts are one of the most prominent methods used by companies to mitigate and manage interest rate risk. Individual retail investors, on the other hand, are less likely to use them, and the market remains largely unavailable to them.
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Factors affecting Forward Contracts
Forward derivatives are important to many areas of the economy since they not only provide price protection but are also easier to comprehend and trade than many other types of contracts.
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Regulators
Forward trading usually does not require any margin and is unregulated by SEBI (Securities and Exchange Board of India).
Major Risks in Forward Contracts
Since many of the globe ‘s largest firms utilise forward contracts to hedge currency and interest rate risks, the market for forward contracts is massive. However, estimating the size of this market is challenging because the terms of forward contracts are only understood by the buyer and seller and are not available to the general public.
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Default
In the worst-case scenario, the forward contracts market’s huge size and unregulated structure make it vulnerable to a rolling series of defaults. While banks and financial firms can reduce this risk by carefully selecting counterparties, large-scale default is still a threat.
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Non-standard Nature
Another risk associated with forward contracts’ non-standard nature is that they are not marked-to-market like futures and are only resolved on the settlement day. What if the contract’s specified forward rate differs significantly from the spot rate at the time of settlement?
The financial institution that initiated the forward contract has a higher level of risk in the event of the client’s default or non-settlement than if the contract were marked-to-market on a daily basis.
Difference Between Forward and Future Contract
| Basis | Forward Contract | Future Contract |
| Trade | These are traded over the counter (OTC). | They are traded at regulated exchanges. |
| Risk | They have a major risk of default. | They don’t have such risks. |
| Contract | There is no Standard Contract | There is a standard contact for all |
| Regulatory | There is no regulatory involved in it. | There is government regulator involved in it. |
| Availability | They are not available for retail investors | they are available for retail investors. |
Conclusion
Forward Contracts are a really helpful tool for hedging in the international market. Most of the big companies use it to reduce their risks.
This is all from our side regarding what is a forward contract? Although, if you have any doubts about forward contract meaning you can just comment below.
Other Interesting blogs related to what is a forward contract?
Frequently Asked Questions About Forward Contract Definition
Features of forward contract?
Since they are bilateral contracts, they are subject to counterparty risk. Each contract is custom-made, therefore the contract size, expiry date, and asset kind and quality are all unique. In most cases, the contract price is not known in the public domain.
A forward contract is a derivative of a
A forward contract is a flexible derivative contract in which 2 parties agree to buy or sell an asset at a predetermined price at a future date. Forward contracts can be customised to a particular product, quantity, and delivery date.
Types of forward contracts?
There are 7 Types of Forward Contracts mainly Window Forwards, Long-Dated Forwards, Non-Deliverable Forwards (NDFs), Flexible Forward, Closed Outright Forward,Fixed Date Forward Contracts and Option Forward Contract.
Currency forward contract?
In the foreign exchange market, a currency forward is a legally binding contract that locks in the exchange rate for the purchase or selling of a currency at a future date. A currency forward is basically a hedging strategy that may be customised and does not require an upfront margin payment.
Forward contract vs future contract?
A forward contract is a private, personalized agreement that is exchanged over-the-counter and settles at the end of the term. A futures contract has fixed terms and is traded on an exchange, with prices settled daily until the contract's expiry.
