What is Forward Contracts?
A forward contract is an agreement to buy or sell an asset at a certain price on a certain date in the future. Since the forward contract implies that underlying assets would be delivered on the specified date in the future which is considered as a type of derivative.
These contracts are mostly traded in the over-the-counter market and are easily customized. For Example- Ram takes the long position agreeing to purchase the underlying asset at a future date for a specified price while Rohan takes the short position in the market agreeing to sell the asset on the same date for that same price.
Characteristics of Forward Contracts
The basic characteristics of a forward contract are given below:
- Two-way: Forward contracts are bilateral in nature as they are exposed to counterparty risk.
- Risky Contracts: There is a risk of non-execution of obligation by either of the parties, so these are much riskier than future contracts.
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Risks associated with Forward Contracts
The market for forward contracts is so big since many of the world’s biggest corporations use it to hedge currency risk and interest rate risks. As the details are restricted to the buyer and seller – and are not shown to the general public – the size of this market is difficult to estimate.
Its size and unregulated nature of the forward contracts market mean that it might be susceptible to a chain of defaults in the worst-case scenario (WCS). On the other hand, banks and financial institutions mitigate the risk by being vigilant while choosing their counterparties and the possibility of large-scale default does exist in the market.
Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not mark-to-market just like futures.
The financial institutions that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were mark-to-market daily.
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How does Forward contracts differ from Future contracts?
Forwards and Futures contracts are almost similar. Both includes the agreement on a certain price and quantity of an underlying asset to be paid at a certain date in the future. There are key differences given below:
- Forwards are customized, negotiable, and privately handled contracts between two parties, while futures are standardized contracts that are traded on centralized exchanges.
- Forwards are settled at the expiration date between the two parties, meaning there is higher counterparty risk than there is with futures contracts that have clearing houses.
- Forwards are settled on the expiration date, while futures are marked-to-market daily which means they can be traded at any time on the exchange.
- Since forwards are settled on a single date, they are not commonly connected with initial margins or maintenance margins like futures contracts.
Though both contracts involve the delivery of the asset or payment in cash, physical delivery is quite more common for forwards while cash settlement is much more common for futures.
Forward Payoff-Chart
The payoff chart of forward contract is given below:
- Forward contract long position payoff: PT – K
- Forward contract short position payoff: K – PT
Where:
- K is the delivery price.
- PT is the spot price of the underlying asset at maturity.
Above Payoff Chart for Forward contract depicts PT for spot price and K for Delivery price.
About the Author: Yash Tanwar
Commerce graduate from University of Delhi who is currently pursuing for FRM Part-1 2020. He wants to obtain a stronger track record of result making and gain something new skill sets that are applicable to Finance specifically in risk domain.
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