Forward Contract: Meaning, Features, Benefits and Risks
Derivatives trading is an excellent way to gain profits by predicting the future value of an underlying asset. There are several types of derivatives contracts that you can trade in, among which forward contracts are important. Read on to know how this type of contract works and its features.
What Is a Forward Contract?
A forward contract is a financial agreement between two parties to buy or sell a specific asset at a fixed price and date in the future. It is a derivatives asset with underlying security which can be stocks, market indices, commodities, foreign currency, etc. This contract also has a specific size that denotes the number of asset units being bought or sold.
Usually, traders use forward contracts when they are speculating or hedging their investments against market volatility. Large companies also use them to mitigate risks and hedge against interest rate risks.
Furthermore, these assets are customizable, are considered over the counter, and are not traded on stock exchanges.
What Are the Features of Forward Contracts?
The primary features of forward contracts are as follows:
- Forward contracts do not fall under the Securities and Exchange Board of India (SEBI) regulations. Thus, they do not have any margin requirements.
- They are not listed or standardised by the stock exchanges and thus are customizable. The buyer and seller can easily make changes to the contract’s terms and conditions as per their requirement.
- To settle these contracts, the parties involved have two options. One is that the seller pays the appropriate differential by cash and does not physically deliver the goods. Alternatively, the individual can just deliver the goods and get the predetermined price from the buyer.
How Do Forward Contracts Work? – An Example
Forward contracts are generally opted by parties due to conflicting views on the future prices of a particular asset.
For a more precise understanding of this matter, let’s take the help of a real-life example. Let’s say a potato farmer aims to sell his produce at ₹6000 per quintal to a chips factory. His harvest is due after 6 months, but he is apprehensive about incurring a loss due to market fluctuations.
So, he enters into a forward contract with the chips factory to sell his produce at ₹6000 per quintal after 6 months. Now, three scenarios can occur depending on the asset’s price movements:
- Market Value of the Asset Rises
If the market value of potatoes rises to ₹6500 per quintal, the farmer will have to provide the assets as per the contract value, i.e., ₹6000. The chips company will profit as it can sell the potatoes in the open market at the current rate.
- Market Value of the Asset Remains the Same
In case the market value of the asset remains the same, there will be neither profit nor loss for either of the parties involved. The trade expires worthless.
- Market Value of the Asset Falls
If the asset value of potatoes depreciates, the farmer will stay protected against the price fall and will be able to sell his produce as per the predetermined value. The company will have to buy the produce as per the contract price.
Benefits of Forward Contracts
Here are a few benefits of trading in forward contracts:
- Forward contracts are perfect for hedging. They allow you to protect your investments from fluctuating market prices.
- These investment vehicles are easy to use and come with lesser regulations. This feature allows you to customise them according to your requirement.
Risks of Forward Contracts
These are some of the risks associated with forward contracts:
- As forward contracts are not under the regulations of stock exchanges, counterparty risks are significantly high.
- They are comparatively less liquid than futures contracts. This is because they do not have a secondary market, and you may face difficulties in finding a buyer who has an investment objective similar to yours.
Now that you have a clear understanding of forward contracts, you can consider trading these derivative contracts. However, it is advisable that before beginning, you gain a deep insight into the workings of these financial agreements. Doing so will assist you in taking the right investment decisions.
Q1. Is it legal to use forward contracts in India?
Ans. Yes, in India, it is legal to use forward contracts for hedging and speculation. However, you cannot trade them on the stock exchanges.
Q2. Can I extend or cancel a forward contract?
Ans. Forward contracts are highly customizable. Thus, you can extend or cancel them before or on their expiry dates.
Q3. Do I have to pay GST on forward contracts?
Ans. Yes, GST is applicable if the contract settlement happens via the physical delivery of goods and the underlying assets are commodities or currencies. This is because they will come under normal supply of goods.
Q4. What are the differences between forward and futures contracts? Ans. Forward contracts are customizable, non-standardized, and are not tradable on stock exchanges. They can be settled on the specified expiration date. On the other hand, futures contracts are standardised and regulated by the stock exchanges. Although they are non-customizable, they can be traded at any time during market hours.