A forward contract is a personalized agreement directly established between two parties to buy or sell an asset on a specified future date, with terms decided at the current moment. Forwards find applications across various markets, including commodities, foreign exchange, equity, and interest rates.
To illustrate the distinction between the cash market and forwards, let’s consider an example. Imagine it’s May 11, 2023, and you want to purchase 10 grams of 24-carat gold. On this day, the market price for this gold is Rs. 62,130. You pay this amount to a goldsmith, who hands over the gold. This transaction is a typical cash market exchange at the “spot price” of Rs. 62,130.
Now, let’s say you don’t wish to take possession of the gold on May 11, 2023, but instead, you want it after one month. The goldsmith quotes you a forward price of Rs. 62,337 for 10 grams of gold. You agree to this forward price, effectively “buying a forward contract” or going “long forward.” In this scenario, the goldsmith has “sold a forward contract” or is “short forward.” At this point, there’s no money or gold exchange. After one month, you return to the goldsmith, pay him Rs. 62,337, and collect the gold. This exemplifies a forward contract where both parties are obligated to fulfill the contract, regardless of the gold’s value at the time of delivery.
Key features of a forward contract include:
Bilateral Contract: It’s an agreement between two parties.
Fixed Terms: All contract terms, such as price, quantity, quality, delivery details, are established on the contract’s initiation.
In essence, forwards are bilateral over-the-counter (OTC) deals where all contract terms are negotiated directly between the parties involved. Any modifications to the contract require mutual consent. Corporations, traders, and investment institutions use OTC transactions to tailor contracts to their specific needs, primarily to mitigate price risk.
However, forwards do have some limitations:
- Liquidity Risk: Forwards can lack liquidity because they are customized contracts not easily accessible to other market participants. They are not traded on exchanges, making it challenging for parties to exit the contract before maturity.
- Counterparty Risk: Counterparty risk, also known as default risk or credit risk, arises if one party fails to meet its contractual obligations. For instance, if the market price of rice changes significantly after a rice forward contract is established, one party may choose to default on the agreement.
To address these issues, standardized futures contracts, which trade on centralized exchanges, were introduced, offering greater liquidity and reduced counterparty risk.