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What are characteristics of forward contracts?
In forward contract both sellers and buyers involve in forward transactions and both are obligated to fulfill their obligations on or before maturity or expiry date. Obligations of forward contract are as follows
- Buy or sell underlying asset at forward price or specific price
- Buy or sell underlying asset at expiry date or on contract maturity or at particular time
- Not traded on exchanges
The main characteristics of forward contracts are explained below −
Not traded − Forward contracts are designed to meet specific requirements of company. These contracts are not traded in the market.
No premium − Since these contracts are not traded in markets, so no premium is involved.
No margin − Small fees are required to enter into a forward contract.
Physical delivery − These are inflexible and bind in nature. Therefore, at the time of delivery, physical delivery is required.
Expensive − More expensive than other hedge options because, these contracts are tailored made.
Let us understand this clearly with an example −
coffee shop owner purchases coffee beans at Rs.300/lb (currently) from a supplier COF. There is a natural calamity waring issued from respective department in the coming days. Hearing this news, the coffee shop owner got worried thinking that the supplier may increase the price, which decreases the profit margin.
But in actual, supplier planned his operations in such a way that natural calamity does not affect production and may produce more beans this year due to planned activities. Now coffee shop owner and supplier negotiated a forward contract and fixed the price at Rs.300/lb and in the next 6 months, the supplier will supply 12000 lbs of coffee beans. Now coffee shop owner gets coffee beans for Rs.300/- irrespective of conditions. Both parties agree and understand the terms in the contract.
If production affected by natural calamity −
In this, price of coffee beans may rise above Rs.300/- (Let us assume Rs.500/lb because of production loss). With current price supplier will get Rs.3600000 (300*12000). With increase price Rs.500/- supplier will get Rs. 6000000 (500*12000) for next 6 months. Supplier loses Rs.2400000 (200*12000) because according to contract his supplier agreed to supply coffee beans for Rs.300/- to the shop owner.
If production is not affected by natural calamity −
The supplier gets more production due to which there is decrease in coffee bean price (say Rs.150/-). Now coffee shop owner pays 3600000/- (300*12000) to the supplier. If price falls and coffee shop owner needs to pay Rs.1800000/- (150*12000) according to new market rate. In this case, supplier gets profit Rs.1800000/- (150*12000) because according to contract shop owners agrees to pay Rs.300/- to the supplier.
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