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Forward Contract
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Forward Contract
Forward Contracts
A forward contract is the most elementary form of derivatives. Over here, two parties enter into an agreement either to buy or sell something at a future date agreed today. It can be customized to cater to the need of both parties entering into the contract. The contract specifies the underlying asset’s contract size or a lot, forward interest rate, settlement date, specified quality, and quantity, and other items to be fulfilled to satisfy the contract.
The assets often traded in forward contracts include commodities, precious metals, electricity, oil, natural gas, foreign currencies, and financial instruments.
Table of Contents
1. Forward Contracts
2. Pricing Assumptions for Forward Contract
3. Closing a Position
4. Settlement for Forward Contract
1. Cash
2. Physical Delivery
5. Purpose
6. Value
7. Merits of Forward Contract
8. Demerits of Forward Contract
Pricing Assumptions for Forward Contract
The following assumptions are used to compute forward prices:
1. There are no transaction costs.
2. No restriction on short sales.
3. There are the same tax rates on all net profits.
4. Borrowing and lending at the risk-free rate
5. Arbitrage opportunities are exploited as they arise.
Closing a Position
In contrast to a futures trade, where a buyer or seller performs an opposite transaction of their original transaction to close a position, for a forward contract to be closed or terminated before the settlement date, there are two ways to do so. Either transfer the contract to a third party or get into a new forward contract with the opposite trade. It is typically complicated to terminate a contract and might attract a penalty. (Read more about Forwards vs Futures).
Settlement for Forward Contract
Forwards can be settled in either of two ways:
Cash
It requires the counterparties to exchange the cash difference in the value of their positions. The appropriate party receives the cash difference.
Physical Delivery
It requires the counterparties to exchange the underlying asset. Herein, the actual quantity of the underlying asset, along with other specifications as stipulated in the contract, are delivered to settle the contract.
After a settlement, there are no further obligations to either party.
Purpose
Generally, forwards are used to hedge/mitigate the price movement risk by locking the price today for the transaction to occur at a future date.
Value
The initial value of a forward contract is zero. The forward contract can possess a non-zero value only after the contract is entered into and the obligation to buy or sell has been made. Since the forward price is regularly computed to prevent arbitrage, the value must be zero at the inception of the contract.
Merits of Forward Contract
A forward contract has the following merits:
1. They are easy to understand.
2. It is a tailor-made contract and is flexible to adjust to the needs of both parties.
3. Offer a complete hedge (i.e., delta neutral hedge) and helps in mitigating the risk.
4. It can be matched with the time period and cash flows of exposure.
5. As it is an over-the-counter (OTC) contract, the price of contracts is not known to others, hence providing price protection.
6. There are no immediate cash outflows before the settlement of the contract but might require an upfront fee, i.e., margin.
7. It is a tool for speculation.
8. Payoffs are symmetrical, meaning thereby, there is a distinction as one party will gain while the other makes a loss of an equivalent amount.
9. There is no daily marking to market requirements as mandatory in the futures contract.
Demerits of Forward Contract
Like every other derivative, forwards also have some demerits as follows:
1. As it is a private contract, there is no liquidity.
2. Counterparty risk of defaulting on the contract is excessively high.
3. The market of forward contracts is extremely unorganized as it is traded over the counter.
4. It may be challenging to find a counterparty to enter into a contract.
Bas du formulaire
Types of Forward Contracts – All You Need to Know
A forward contract is a type of derivative instrument. This is an agreement between two investing parties wherein the parties agree to buy or sell an underlying asset or security at a future date at an agreed rate in the agreed quantity. These contracts trade OTC (over the counter), and thus they do not face many regulations and are not standardized. There are many types of forward contracts, which we will discuss later in this article.
Traders primarily use forward contracts to protect themselves from the volatility in the currency and commodity markets. But, forward contracts can involve other assets as well, including equity, treasury, real estate, and more. Forward contracts are useful as a hedging instrument. However, it is also used by investors for speculation purposes to earn profits from the movement of the security prices.
Table of Contents
1. Types of Forward Contracts
1. Window Forwards
2. Long-Dated Forwards
3. Non-Deliverable Forwards (NDFs)
4. Flexible Forward
5. Closed Outright Forward
6. Fixed Date Forward Contracts
7. Option Forward Contract
2. Final Words
3. Frequently Asked Questions (FAQs)
Now, as we know what forward contracts are, let us take a look at the types of forward contracts.
Types of Forward Contracts
Since currencies account for the bulk of forward contracts, most types of forward contracts are specific to currencies. Following are the types of forward contracts:
Window Forwards
Such forward contracts allow investors to buy the currencies within a range of settlement dates. Basically, such contracts allow investors to get a more favorable and convenient exchange rate than what they would get by using a standard forward contract.
Also Read: Forward Contract
For example, Mr. X is supposed to make a settlement with his US-based supplier after three months. However, the date is not fixed. Therefore, Mr. X opts for a window forward contract where he can trade on any day from 1st to 30th of the upcoming 4th month but not later than 30th.
Long-Dated Forwards
As the name suggests, the settlement period of such contracts is much more than the usual forward contracts. A standard forward contract usually has an expiry date of up to 12 months. In contrast, long-dated forwards can have a maturity date of up to 10 yrs. Except for a longer settlement date, all other features of long-dated forwards are the same as standard forward contracts.
Non-Deliverable Forwards (NDFs)
Non-deliverable forwards are types of forward contracts that are very different from standard forward contracts. As in such contracts, physical delivery of the security/asset of funds does not occur. Instead, the parties just exchange the difference amount at the time of the settlement. The difference amount is on the basis of the contract rate and the market rate at the time of the settlement. Generally, investors who do not have enough funds or do not want to commit funds or block huge funds go for such types of forward contracts.
Suppose XYZ Inc. will receive 1 million BRL after 3 months for sales made in the current month. It goes to a Brazilian bank in order to enter into a forward contract of selling 1 million BRL after 3 months at a rate of 4 BRL for $1.
Also Read: Non-deliverable forward (NDF)
Now, there are 2 possibilities:
Case 1: After 3 months, $1 = 3.7 BRL, or
Case 2: After 3 months, $1 = 4.25 BRL.
XYZ Inc. would receive $250,000 for sure because of entering into an NDF contract.
In case 1, amount to be received by XYZ Inc. = $270,270 (1 million BRL / 3.7). Here, the spot price turns favorable for XYZ Inc. Now the Brazilian bank will pay the difference of the spot rate and forward rate to XYZ Inc., which is $20,270 (i.e., 270,270 – 250,000).
In case 2, amount to be received = $235,294 (1 million BRL / 4.25) which is less than $250,000. Here, spot price is unfavorable for XYZ Inc. Now the difference paid by the bank is $14,706 (i.e., 250,000 – 235,294).
Flexible Forward
Such type of forward contract gives investors flexibility in exchanging the funds. Or, we can say that investors using such a contract have an option to exchange the funds before the settlement date. Using this contact, parties can either exchange the funds outright or choose to make several payments prior to the settlement date.
Assume that Mr. X imports goods in India worth $500,000 from a US-based exporter. Being aware of exchange rate fluctuation, he enters into a flexible forward contract. This will help him to make payments at different points of time during the period of the contract, whenever the exchange rates are favorable to him.
Closed Outright Forward
This is the simplest type of forward contract. We can also call such forward contracts European contracts or Standard Forward Contracts. Such types of contracts allow investors to exchange the underlying asset at a specific future date.
Say, for example, you have entered into a trade with a foreign exporter. And, the date of payment is the 24th of next month. You can lock in the exchange rate by entering into a closed outright forward contract for the 24th of next month.
Fixed Date Forward Contracts
In this type of forward contract, the parties exchange the underlying asset only at specific maturity date. Or, we can say, such contracts have a fixed maturity date. Most forward contracts are fixed-date forward contracts only.
Option Forward Contract
These types of forward contracts are similar to flexible forward contracts. An option forward contract allows parties to exchange the underlying security on any date during a specific
period.
Final Words
So, these were the types of forward contracts that investors have at their disposal. They can select one or more forward contracts depending on their position, risk appetite, as well as the current market scenario.
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