Features of forward contract include:
- Non-standardised and over-the-counter (OTC)
- Customizable agreements
- Settlement options
- Risk hedging for corporations
- No margin requirement
What Is the Forward Market?
The forward market is akin to a vast informal bazaar where participants negotiate future trade prices. Imagine in India, securing mangoes for next month at a prearranged price, resembling forward contracts where buyers commit to purchase goods at agreed-upon rates before delivery.
It’s especially popular for trading foreign money. For example, if you’re running a business and you know you’ll get dollars in three months, but need rupees now, you can use the forward market. You agree on a rate with someone to exchange your future dollars for rupees. This helps you avoid the risk of dollar prices changing unexpectedly.
Features Of Forward Contract
The main features of forward contracts include their non-standardized, over-the-counter nature, like custom-made deals, not traded on exchanges like BSE or NSE. They’re flexible, customizable agreements ideal for unique business needs, offering physical/cash settlement options, useful for risk hedging, and require no margin upfront.
Non-standardized and Over-the-Counter (OTC) is a characteristic indicating that forward contracts are not traded on formal exchanges and don’t have standardized terms. This means they are negotiated directly between two parties, usually financial institutions or companies. For example, two companies might enter into a forward contract where the terms, such as quantity and price of a commodity, are tailored to their specific needs.
Customizable Agreements are forward contracts that can be tailored to the specific requirements of the parties involved. Unlike standardized futures, forwards can be customized in terms of the asset type, quantity, quality, delivery time, and price. For example, a food manufacturer might enter into a forward contract with a farmer to buy a specific type of wheat at a set price and date that isn’t available in standardized futures markets.
Settlement Options in forward contracts mean that the parties can decide how they want to settle the contract – either through physical delivery of the asset or cash settlement. This flexibility allows parties to choose the most convenient settlement method. For example, a company might prefer cash settlement for a commodity forward contract to avoid the hassle of dealing with the physical commodity.
Risk Hedging for Corporations is a feature where companies use forward contracts to protect themselves against price fluctuations in the market. This is particularly useful for businesses that need to plan their budget in advance. For instance, an airline company might use forward contracts to lock in fuel prices, reducing the risk of price increases in the future.
No Margin Requirement is a trait of forward contracts where parties are not required to deposit any margin upfront. Unlike futures, where a margin is needed to cover potential losses, forward contracts rely on the creditworthiness of the parties involved. This means that there’s a higher risk of one party defaulting, but it also provides more flexibility. For example, a small business entering into a forward contract won’t need to tie up capital in a margin account.
Features Of Forward Contract – Quick Summary
- The main features of Forward Contract are Customizable agreements between buyers and sellers to trade at a fixed price on a future date, without standardized terms or margin requirements.
- Forward Market is like a marketplace for agreeing on future prices. Businesses use it to secure deals for currencies or goods, avoiding unexpected price changes.
Features Of Forward Contract – FAQs
What is the main feature of a forward contract?
A forward contract is a private agreement to buy or sell assets at a predetermined price in the future, offering risk management for businesses without exchange trading or margin requirements.
What are the benefits of a forward contract?
The main benefits of Forward contracts include price certainty, customization, budget planning, protection against currency fluctuations, and suitability for international transactions, mitigating future cost uncertainties and risks.
What are the two types of forward contract?
There are two main types of forward contracts: ‘Fixed Date Forward Contracts’ where the trade happens on a specific date, and ‘Option Forward Contracts’ which give more flexibility on when to trade.
How is the forward contract calculated?
The main benefits of Forward contracts include predicting future dividends using the risk-free force of interest, assuming risk-free conditions for reinvestment at prevailing rates.
Forward Price = Spot Price – Cost of Carry
Can forward contract be Canceled?
Customers can cancel short or long-term forward contracts and rebook them at the current exchange rate. The cancellation is done at the prevailing selling or buying rate.
Who can book a forward contract?
Forward contracts can be booked by businesses, investors, or individuals needing to hedge against price fluctuations or currency risks, and those with specific trade requirements not catered to by standard exchanges.
Are forward contracts legal?
Forward contracts, under the 1952 Forward Contracts (Regulation) Act, are binding agreements between two parties to exchange an asset at a predetermined price and date, with specific regulations for trading items like commodities.
