Forward contract

In finance, a forward contract or simply a forward is a derivative contract between two

parties to buy or to sell an asset at a specified future time at an amount agreed upon today.
The party agreeing to buy the underlying asset in the future assumes a long position, and
the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the delivery price, which is equal to the forward price at the
time the contract is entered into. The price of the underlying instrument, in whatever form,
is paid before control of the instrument changes.
The forward price of such a contract is commonly contrasted with the spot price, which is
the price at which the asset changes hands on the spot date. The difference between the
spot and the forward price is the forward premium or forward discount, generally
considered in the form of a profit, or loss, by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a
quality of the underlying instrument which is time-sensitive.
Forward contracts are closely related to futures contracts however, they differ in certain
respects. Forward contracts are non-standardized. Thus, they are not exchange-traded, or
defined on standardized assets. Forwards are not marked to the market and thus typically
have no interim partial settlements as far as margin requirements are concerned. So, the
parties do not exchange margin variations which secure the party at gain and the entire
unrealized gain or loss builds up while the contract is open.
Notwithstanding the above, forwards are traded over the counter (OTC) and their
specification can be customized and may include mark-to-market and daily margin calls.
Forward trading mechanism
In early years, transportation facilities for goods were not as per the present standards.
Hence, a lot of time was consumed to transport goods to their destination. Sometimes it
took so much time that the prices drastically changed and even the producers of the goods
had to sell at loss. Producers, therefore, thought to avoid this price risk and they started
selling their goods forward even at the prices lower than their expectations.
For example, a paddy farmer could sell the produce forward to the miller and by the time
the actual goods reached the mill, he could have protected himself against the unfavourable
price movements of the future. This is known as short selling. On the other hand, the miller
assumed the long position and agreed to buy the paddy at a specified price and on a
particular date. For this trade, a dalal or middleman is needed who knows the price
expectations of the farmer and the miller and he charges a fee from both of them for this
purpose known as commission.
In this example, the farmer entered into the forward contract to avoid price risk. Then the
question arises, why did the miller enter into the contract and buy forward? Here, it must be
understood that the farmer and the miller are not the only participants of this particular
value chain. There are other participants in the value chain as well such as the marketeer,
the dealer, the retailer and the end user or the consumer. The mill owner might have an
obligation to the next participant of the value chain due to which he entered into the
contract and bought forward. He might have to fulfil a future commitment of delivering rice
at an already agreed upon price to the marketeer and in order to protect his profit margin,
the miller made forward purchase of the paddy from the farmer. In the process, the miller
also avoided the price risk and insured his profit margin by taking the long side of the
forward contract with the farmer. Thus, both parties in the forward contract are in a win-
win position.
Features of forward contract
Bilateral contracts: Forward contracts are bilateral in nature. In other words, there are two
parties to the contract. Due to the bilateral nature of forward contracts, they are exposed to
counterparty risk.
Riskier than futures: As forward contracts are not regulated, there is risk of non-
performance of obligation by the counterparties. Therefore, forwards are riskier than
futures contracts.
Customized contracts: Forward contracts are custom designed or tailer made as per the
requirements of the counterparties. Hence, each contract is unique in terms of contract size,
expiration date, the asset type, quality, etc.
Long and short positions: In a forward contract, one of the parties takes a long position by
agreeing to buy the asset on a specified future date at an agreed price. The other party
assumes a short position by agreeing to sell the same asset on the same future date and for
the same agreed price.
Delivery price: The agreed price in a forward contract is referred to as the delivery price.
However, delivery price is different from the forward price. Both are equal at the time the
contract is entered into. As time passes, the forward price is likely to change whereas the
delivery price remains the same.
Expiration: On the date of expiration, the forward contract has to be settled by the
discharge of obligations by the counterparty. In most cases, settlement of the contract is
done by delivery of the underlying asset on the date of expiration.
Synthetic assets: Forward and Futures contracts can often be used as synthetic assets. A
synthetic asset is a combination of assets which when combined would have the same effect
and value as another asset. One common way of creating a synthetic forward or future is:
(1) buying an ATM CE and selling ATM PE will give the effect of forward long; and (2) buying
ATM PE and selling ATM CE will give the effect of forward short. In other words, it creates
the same effect as actually buying or selling the forward or the future.
Reversal of contract: In case the party wishes to reverse the contract, it has to compulsorily
go to the same counter party, which may dominate and command the price it wants as
being in a monopoly situation.
Useful for hedging: Though forwards can be used for hedging, speculation and arbitrage,
the non-standardized nature of such contracts make them particularly useful for the
purpose of hedging by parties with large exposure.
Highly popular in forex market: Forward contracts are very popular in foreign exchange
market as well as interest rate bearing instruments. Large banks throughout the world
quote the forward rate of hard currencies through their ‘forward desk’ lying within their
foreign exchange dealing room.
Classification of forward contracts
Deliverable forward contracts: Deliverable forward contracts are legally enforceable and
customised agreements which are performed by specific delivery of goods.

In accordance with the Forward Contracts (Regulation) Act, 1952, two types of deliverable
forward contracts can be made.

1) Transferable specific delivery (TSD) contracts: Transferable specific delivery contracts are
legally enforceable and customised agreements which are performed by transferring the rights
or liabilities through documents of title to the goods such as delivery order, railway receipt, bill
of lading, warehouse receipts etc., while giving specific delivery of goods is also mandatory for
the performance of the contract. TSD contracts may be multilateral in nature and may involve
parties other than the buyer and seller.

2) Non-transferable specific delivery (NTSD) contracts: Non-transferable specific delivery

Contracts are legally enforceable and customised agreements which are performed by giving
specific delivery of goods while merely transferring the rights or liabilities through documents of
title to the goods such as delivery order, railway receipt, bill of lading, warehouse receipts etc.,
does not amount to performance of the contract. NTSD contracts are bilateral in nature and
involve the buyer and seller only.

Non-Deliverable forward contracts: Non-deliverable forward contracts are legally enforceable

and customised agreements which are not performed by specific delivery of goods but by
settling the payoffs calculated on the notional amount.