15 Feb, 2025
4 mins read
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A forward contract is a financial deal between two parties for the buying or selling of an asset on a specified date at a specified price. Forward contracts are typically employed to hedge against price risk and financial risk management. They are typically tailor-made and traded over-the-counter (OTC).
Forward contract meaning - A forward contract is nothing but a simple agreement between a buyer and a seller at a predetermined price for delivery in the future. It is intended to help business houses and investors hedge prices and shield them against future price uncertainty. It is widely used in commodity, currency, and interest rate markets.
For instance, an exporter who is to receive payment after three months in a foreign currency can enter into a forward contract to lock the exchange rate and prevent losses arising from currency fluctuations.
The operation of a forward contract is straightforward:
1. Two parties agree on the asset, price, and future date.
2. The transaction is settled on the specified date, irrespective of the market price at that time.
3. No money is paid at contract entry but only at settlement.
4. The contract is binding because both parties are committed to completing their obligations unless they decide to close out their positions before expiration.
Here are some features of forward contracts that make them valuable in financial planning:
Customisation - The terms of the contract, including price, quantity, and maturity date, can be tailored to suit the needs of both parties.
No Exchange Involvement - Unlike futures, forward contracts are traded directly between parties without exchange oversight.
Counterparty Risk - Since these contracts are not standardised, there is a risk that one party may default on its obligation.
Settlement at Expiry - The contract is settled on the pre-agreed date, with the buyer paying the agreed price regardless of the market value.
There are different types of forward contracts depending on the underlying asset:
1. Currency Forward Contracts - Utilised for hedging exchange rate movements while trading and investing overseas.
2. Commodity Forward Contracts - Typical for agriculture, oil, and metals for price protection of producers and users.
3. Interest Rate Forward Contracts - It assists companies in hedging interest rates so that borrowing rates can be locked in advance.
4. Forward Contracts of Equity - Used for hedging in stock investment to enable investors to lock the sale or purchase price.
There are numerous benefits of forward contracts:
Saves businesses and investors from unwanted price movements.
Facilitates budgeting and financial planning as the future expense is fixed.
Firms that undertake foreign currency dealings can hedge forex risk through the use of forward contracts.
Forward contracts differ from options contracts, where there is an upfront premium to be paid.
The parties can negotiate the terms themselves, thus making forward contracts flexible and customised.
Let’s look at a few examples of forward contracts to better understand how they work.
Agricultural Forward Contract: A coffee farmer agrees to sell 1000 kg of coffee beans to a buyer at a fixed price of ₹1000 per kg, deliverable after six months. Even if market prices drop, the buyer still pays ₹1000 per kg, ensuring price security for the farmer.
Currency Forward Contract: An Indian company expects to receive $100,000 in three months from a U.S. client. To avoid exchange rate fluctuations, it enters a forward contract with a bank to lock in the exchange rate at ₹88 per dollar. This guarantees predictable revenue regardless of currency movements.
Interest Rate Forward Contract: An Interest Forward Rate Contract helps a company lock in an interest rate for a future loan.
For example, if a company plans to take a ₹10 crore loan in 3 months for 6 months and enters an Interest Rate Contract at 7%, the bank and company settle the difference based on the actual market rate on the fixed date:
If the market rate rises to 8%, the bank pays the company ₹5 lakh.
If the market rate falls to 6.5%, the company pays the bank ₹2.5 lakh.
This protects against interest rate fluctuations without an actual loan exchange.
Forward contracts are essential financial tools that offer businesses and investors protection against price volatility. While they provide significant benefits, it is crucial to consider the associated risks before entering into an agreement. By learning about forward contracts, their features, and benefits, people and businesses can make better financial choices.
A forward contract is a private agreement between two parties to buy or sell an asset at a fixed price on a future date. It helps businesses and investors manage price risks and financial uncertainty.
The main difference is that forward contracts are private, customisable agreements traded over-the-counter (OTC), while futures contracts are standardised and traded on regulated exchanges. Futures also involve daily settlements, whereas forwards are settled on the contract maturity date.
There is no fixed limit, but most forward contracts range from one month to a year. However, some contracts can extend up to five years, depending on the agreement between parties.
The primary risks include:
Calculate your Net P&L after deducting all the charges like Tax, Brokerage, etc.
Find your required margin.
Calculate the average price you paid for a stock and determine your total cost.
Estimate your investment growth. Calculate potential returns on one-time investments.
Forecast your investment returns. Understand potential growth with regular contributions.
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