Forward Contract Meaning And its Importance
Derivative security depends on the value of the underlying security or asset. The first official derivatives were recorded in 1848 in Chicago, where the underlying security or asset was wheat. A derivative thus itself has no intrinsic value. Whether regulated or self-regulated, derivative securities are traded either over the counter privately with counterparties or at publicly disclosed prices at centralised exchange markets (for example, the Bombay Stock Exchange).
A forward contract is a type of derivative transaction where the traders privately agree in the absence of any regulatory exchange market. According to their convenience, it is a customised contract where traders specify its terms, quantity, and expiry date. The trader who buys the forward contract enters a long position, while the trader who sells the asset enters a short position. A forward contract allows greater flexibility to the traders but also has an increased credit or default risk.
Additional read: What is a derivative contract?
How forward contracts are traded
Forward contracts are traded through OTC platforms instead of trading on the exchange. Assets are delivered on completion of the specified time in either of these two ways –
Physical delivery:Assets are transferred from the short position to the long position in the same way as pre-decided at the contract's start. For example, A in the long position agrees with a television company to buy a TV three months later at the current price of the TV. After three months, the TV company in the short position sells a TV to A at the specified price. There is no change in this delivery process, and A is unaffected by any change of price in the TV three months later. That is the physical delivery of the asset, TV.
Cash settlement:This method is used when the delivery process is not so simple. For example, A and the TV company in the earlier example had entered into a forward contract with customised specifications. Still, after the contract's maturity, the TV company faces a price drop in the specified asset. It may then request A to buy the TV at a lesser price from the open market while the TV company can pay A the remaining amount. It means the contract is cash-settled instead of delivering the actual asset.
Critical Advantages of Forward Contract
Being self-regulated, forwards ensure greater flexibility in terms of –
Customisation:Counterparties can enter into forward contracts tailored for their specific requirements that include expiry date, lot size, and consensual pricing
Hedging:The pre-decided specifications made by counterparties allow them to manage risks and protect themselves from market fluctuations that could affect the price of the asset
Simplicity:As a contract, it is simpler to understand price protection and enable proximity among traders with less regulation.
Critical Disadvantages of Forward Contract
Despite the popularity of forward contracts in the derivatives market, it cannot ensure –
Transparency:In the absence of a regulatory body, if either of the parties fails to honour the contract, its completion can get muddled
The extent of the forwards market:Due to the informal nature of the contract, the extent of the forward market cannot be fully known
Profits:Hedging, while offering protection, can also mean less profit if the price of the asset drops after the expiration date
Additional read: How is a forward contract different from a futures contract?
Importance of Forward Contract
Despite its disadvantages, a forward contract is fundamental to understanding the derivatives market. Its simplicity, price protection feature, and relative immunity from regulatory norms of formalised exchange markets afford the smaller players access capital and hence crucial to sustaining the overall economy.
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