BTL 704 - Forward Contracts

 

The Banking Tutor’s Lessons

BTL 704                                                                          15-09-2024

Forward Contracts

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.

A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.

Forward contracts can be tailored to a specific commodity, amount, and delivery date. 

Forward contracts do not trade on a centralized exchange and are considered Over-The-Counter (OTC) instruments.

For example, forward contracts can help producers and users of agricultural products hedge against a change in the price of an underlying asset or commodity. 

Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk compared to contracts that are marked-to-market regularly.

A Forward contract can be customized to a commodity, amount, and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.

Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.

Because of their potential for default risk and lack of a centralized clearinghouse, forward contracts are not as easily available to retail investors as futures contracts. 

Example of a Forward Contract

Consider the following example of a forward contract. Assume that an agricultural producer has twenty thousand of paddy bags to sell six months from now and is concerned about a potential decline in the price of corn.

Then he enters into a forward contract with his financial institution to sell twenty thousand paddy bags at a price of Rs 4500/- per bag in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

It is exactly  Rs 4500/- per bag.  In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.

It is higher than the contract price, say Rs 4800/- per bag.  The producer owes the institution Rs 6000/- (20 x 300)  or the difference between the current spot price and the contracted rate of Rs 4500/-.

It is lower than the contract price, say $ 4200/- per bag. The financial institution will pay the producer Rs 6000/- (20 x 300) or the difference between the contracted rate of Rs 4500/- and the current spot price. 

Risks of Forward Contracts

The market for forward contracts is huge since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller—and are not known to the general public—the size of this market is difficult to estimate.

The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.

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 marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?

In this case, the financial institution 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 marked-to-market regularly.

Forward Contracts vs. Futures Contracts

Both forward and futures contracts involve the agreement to buy or sell a commodity at a set price in the future. But there are slight differences between the two. While a forward contract does not trade on an exchange, a futures contract does.

Settlement for the forward contract takes place at the end of the contract, while the futures contract settles on a daily basis. Most importantly, futures contracts exist as standardized contracts that are not customized between counterparties.

Tail Notes

Seller's Option:

A seller's option, often used in conjunction with a forward contract, gives the seller the right to choose some of the delivery specifications.

Long-Dated Forward:

A long-dated forward is a type of forward contract commonly used in foreign currency transactions with a settlement date longer than one year away.

Short Date Forward:

A short date forward is an exchange contract involving parties that agree upon a set price to sell/buy an asset in the future that is short-term.

Buying Forward:

Buying forward is when a commodity is purchased at a price negotiated today for delivery or use at a future date.

Sekhar Pariti

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