Investors often consider forward contracts the basis of everything related to derivatives. A forward contract refers to signing a financial contract between two parties for buying or selling an underlying asset at a future date. This article explains the meaning and example of forward contracts to help you understand whether this trading instrument is the right one for you or not.
What is the Meaning of Forward Contract?
In simple terms, forward contract refers to a legal, financial agreement between two parties to buy or sell an underlying asset at a predefined price on a future date. The underlying asset may be stocks, indices, currencies, or commodities. The value of the forward contract depends on the underlying asset's value, a reason it is known as a derivative. A forward contract is much like a futures contract, except that forward contracts are traded over the counter. This is why forward contracts are also known as OTC derivatives.
While futures contracts are standardised and are overseen and managed by a stock exchange, such as the National Stock Exchange (NSE), forward contracts are executed by two parties outside the purview of an exchange. However, it is wise to note that a forward contract is an obligation, meaning both parties must honour the contract on the date of expiry.
Forward contracts or OTC derivatives are completely customisable and are preferred more by large financial institutions, banks, big brokerage houses, and the like. Also, the stock exchange usually acts as the counterparty for futures or options contracts. But, since forward contracts do not take place through exchanges, they are exposed to counterparty risks.
Now that you know the meaning of a forward contract, let's understand it with an example.
An Example of Forward Contract
On 1st February, Ramesh and Sunita connect with one another through a broker-dealer facilitating forward contracts. They decide to trade an underlying asset without the interference of a stock, commodity, or currency exchange. While Ramesh believes that the underlying asset's price will increase before 24th February (the expiry date), Sunita believes that the underlying asset's price will decline before 24th February. Hence, Sunita becomes the seller, and Ramesh becomes the buyer.
Since the forward contract is based on an underlying asset, both parties will track the asset price closely until 24th February. There may be the following three situations after both parties sign the forward contract deal:
1. The Asset Price Increases
If the asset price increases before the expiry, the buyer of the asset, Ramesh, is considered the winner. The profit made by Ramesh will be equal to the difference between the buy price mentioned in the forward contract and the price of the underlying asset on 24th February.
2. The Asset Price Decreases
If the asset price decreases, Sunita will be the winner. Since a forward contract is also an obligation, Ramesh has to buy the underlying asset from Sunita at a higher price than the asset's current market price. Sunita's gain will be the difference between the price mentioned on the forward contract and the asset's current market price.
3. The Asset Price Remains the Same
In the unlikely scenario where the asset price remains the same, neither Ramesh nor Sunita wins the trade. This means none of them incurs a loss or profit, and trade expires worthless.
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