What is the forward contract?

A forward contract is an agreement between two parties where, one party agrees to buy second party asset on a particular future date at a fixed price. This is a type of derivative financial instrument. It has right and obligation to be executed.

In this contract, a buyer is called LONG and seller is called SHORT. Banks, investors and hedge funds use forward contracts. Here, both parties will hold their position till contract expires.

Components of forward contracts

• Asset − underlying asset which is specified in contract

• Expiration date − date at which asset is delivered and paid

• Quantity − amount or size of asset which is being sold or bought

• Price − amount paid on expiration date

Settlement of Forward contracts

• Delivery base − Deliver the asset and take the cash

• Cash based − If the asset price falls, difference amount is paid by long and short.

Types

The two types of forward contract are as follows −

• Equity forward − In this, purchase of individual stock, stock portfolio, stock index at future date.

• Bond and interest rate forward − Bonds must contain provision because bonds contain default risks.

Used for

Forward contracts mainly used to hedge against losses which are potential in nature. These contracts enable price lock in future. These are important for industries which experiences high price volatility in markets. Forwards contracts can also be used for speculative purposes.

Types

• Closed outright forward − parties agree to exchange curries at future date. In this exchange price is fixed

• Flexible forward − parties exchange funds before settlement date

• Long-dated forward − in this settlement date is extended (generally more than a year)

• Non-deliverable forward − difference in contract and spot rate is exchanged at maturity time.

Advantages

• Protects against fluctuate exchange rates.

• Hedge against risk.

• Highly customized

• Not upfront cost (hedging)

• Low trade risk (internationally)

Disadvantages

• Possibility of default.

• Chance of product quality vary from original promise.