A forward contract is a derivatives contract that derives its value from an underlying asset. It is a contract between two parties to buy or sell an asset at a predetermined price on a future date. A forward contract is physically settled, which means it is considered to be fulfilled when the goods are exchanged.
Forward contract example
Forward contracts were first used by farmers. Let’s understand how a forward contract works with the help of an example of a rice farmer Mr Iyer who is based out of Madurai. Now, cultivation of crops is not an easy job. A farmer needs to plough the fields, sow the seeds, use fertilisers, ensure adequate irrigation etc. Also, he ends up investing a substantial amount of time, energy and resources. But the farmer earns money or returns on his produce only after selling the rice. His entire income is dependent on the produce.
So, let’s assume that currently rice is being sold at ₹20 per kg. If the price of the rice goes down, he will make losses. And if the price goes up, he stands to gain.
Hence, Mr Iyer would like to eradicate this uncertainty. So, he enters into an agreement with Mr. Raj, who is a wholesaler in Kolkata. The agreement states that Mr Raj will buy 500 kgs of rice at the price of ₹20 per kg, two months from now from Mr Iyer. This quantity of rice will be delivered to Mr Raj’s warehouse through trucks and the cost of transportation will be borne by Mr. Raj.
It means, in this scenario, Mr Iyer is the seller and Mr Raj is the buyer of this forward contract. The predetermined quantity of rice to be sold is 500 kgs and the price at which the rice will be sold is ₹20 per kg. Hence, the price of forward contract is ₹10,000 (500 * 20), which derives its value from the underlying – rice.
The contract will be fulfilled on a future date – two months from now. This is when the rice will be delivered to Mr Raj’s warehouse and Mr Iyer will receive ₹10,000. As this a customisable derivative contract terms such as delivering of rice to the warehouse and footing the transport costs can be incorporated into the contract. Also, both the parties in this transaction must agree on these terms.
Advantages of forward contracts:
- High degree of customisation: Forward contracts can be customised to suit the requirements of the parties involved.
- No margin requirement: While trading in forward contracts, no prerequisite margin is required.
Risks involved in forward contracts:
- Counterparty risk: If either of the parties involved decline to honour the contract, the deal will not be completed. This is known as the counterparty risk.
- No regulator: This is an over-the-counter (OTC) agreement, and there is no third-party regulator involved. Simply put, there is no one to hold both the parties accountable.
In order to overcome the risk associated with forward contracts, future contracts were introduced.
Future contract
A future contract is a standardised derivatives contract that derives its value from the underlying asset. It is a contract between two parties to buy or sell an asset at a predetermined price and quantity on a specified date in the future. Future contracts are standardised in terms of quality and quantity to facilitate trading on a futures exchange.
Here, exchanges act as a regulator to eradicate the risk of a default. In order to trade in futures, both the buyer and the seller need to keep a margin. A margin refers to the minimum amount that needs to be in your account before you take a position (trade) in the market.
A mark-to-market (daily settlement of profit and loss) margin should be maintained in the account at all times. A future contract can be physically settled (i.e. it is considered to be fulfilled when the goods are exchanged) or cash settled.
Forwards vs futures: Key differences
| Forwards | Futures |
|---|---|
| Difficult to close the contract before expiry | The order matching is electronic, the buyer and the seller remain anonymous |
| The buyer and the seller know each other | Settlement on a daily basis (through mark-to-market) |
| Privately traded between parties | Can be closed anytime during the trading session |
| High counterparty risk | Traded only when exchanges are open |
| Customisable contracts | Publicly traded on exchange |
| Settlement on expiry | Standardised contracts |
| Traded on all days | No counterparty risk |