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| Corporate Practice bd |
What is Forward-contract? Features, Examples
A forward contract is a customized agreement between two parties to buy or sell an asset (such as currencies, commodities, or securities) at a predetermined price (the forward price) on a future date (the delivery or expiration date). It is a type of derivative contract that allows parties to hedge against or speculate on future price movements of the underlying asset.
Here are the features of a forward contract:
Customization:
Forward contracts are highly customizable, allowing parties to tailor the terms of the agreement to their specific needs, including the underlying asset, quantity, forward price, and delivery date.
Private Agreement:
Forward contracts are typically traded over-the-counter (OTC) directly between the two counter parties, rather than on an exchange. As a result, they are private agreements with terms negotiated directly between the parties involved.
Fixed Terms:
The terms of a forward contract, including the forward price and delivery date, are fixed at the time of initiation. Both parties are obligated to fulfill the terms of the contract on the agreed-upon date.
No Initial Payment:
Unlike futures contracts, which require an initial margin payment, forward contracts do not require any upfront payment. The parties agree to settle the contract at maturity based on the forward price.
Credit Risk:
Since forward contracts are not traded on an exchange and do not require an initial margin, they are subject to credit risk. Each party is exposed to the credit risk of the counter party defaulting on the contract.
No Standardization:
Unlike futures contracts, which are standardized and traded on exchanges, forward contracts are not standardized. Each forward contract is unique and tailored to the specific requirements of the counter parties.
Example of a Forward Contract:
Suppose Company A, a US-based importer, needs to purchase 10,000 barrels of crude oil from Company B, an oil producer, in six months. However, Company A is concerned about potential price fluctuations in the oil market that could affect its costs.
To hedge against the risk of rising oil prices, Company A enters into a forward contract with Company B. They agree to buy 10,000 barrels of crude oil at $70 per barrel in six months' time.
Features of this forward contract include:
Customization:
The contract is tailored to the specific quantity of oil (10,000 barrels), forward price ($70 per barrel), and delivery date (six months).
Private Agreement:
The contract is negotiated directly between Company A and Company B without involving an exchange.
Fixed Terms:
The forward price of $70 per barrel and the delivery date in six months are agreed upon at the initiation of the contract.
No Initial Payment:
Neither Company A nor Company B is required to make an upfront payment when entering into the forward contract.
Credit Risk:
Both parties are exposed to credit risk, with each relying on the other to fulfill their obligations under the contract.