The Indian secondary market which is commonly referred to as the stock market, allows you to trade in stocks and derivatives. Derivatives are amongst the most preferred choice of traders and investors due to a number of advantages over conventional stocks.
Forward contracts are contracts between two or more parties for buying or selling a particular asset on a future date at a pre-decided price. The forward contracts are widely used for speculation and hedging. Forward contracts or forwards are very similar in nature to futures. The point which differentiates forwards from futures is that unlike forwards, futures are not traded on the exchange. Forwards are only traded over the counter. When creating a forward contract, the buyer and seller can customize the terms, size and settlement process of the derivatives. Being an over the counter instrument, forward contracts carry more counter-party risks for both seller and buyer.
Let us now discuss in detail about forward contracts.
So, without further ado let us discuss about forward contracts in detail. It must be noted that forward contracts are not traded on the Indian exchanges.
1. What are Forward Contracts
Forward contracts are OTC contracts which means that they are traded Over the Counter. These are not standardized contracts are therefore are not traded on the exchanges. The OTC nature of these contracts makes it easier for the users to customize terms. However, there is a high level of default risk associated with these contracts due to the lack of a centralized clearing house.
Forward contracts can be customized as per the need based on the underlying asset, amount and delivery date. Forward contracts are not easily available to retail investors when compared to the futures contracts.
2. Forward contracts vs Futures
Forward contracts and futures contracts are very much similar in nature. Both forwards and futures contracts involve buying or selling an underlying asset at a set price in the future. The key point which differentiates forward contract from futures is that forward contracts are not traded on the exchange. Forward contracts are settled at the end of the contract tenure, whereas the profit and loss for futures contracts is set on a daily basis. Above all, the main highlight with futures contracts over forward contracts is that futures are standardized contracts which are not customized unlike futures between counter parties.
3. Example of Forward Contracts
Let us understand forward contracts better with the help of a very simple example. Imagine a farmer who has 2000 quintals of wheat harvest to sell eight months from now. However, he is concerned about a potential decline in the price of wheat over this period. He thus enters into a forward contract with his financial institution to sell 2000 quintals of wheat at the price of Rs 2800 per quintal in eight months, with settlement on a cash basis.
After eight months, the sport price of wheat has three possibilities:
It is exactly Rs 2800 per quintal – In this case, there will be no monies owed by the farmer or the financial institution to each other and the contract will be closed.
It is higher than Rs 2800 per quintal – Now in this case, the farmer owes the extra amount over Rs 2800 per quintal.
It is lower than Rs 2800 per quintal – In this case, the financial institution will pay the producer the difference amount between the contracted rate of Rs 2800 and the current spot price.
4. Risks with Forward Contracts
Forward contracts are used by many of the world’s biggest corporations for hedging currency and interest rate risks. The insights about forward contract are difficult to estimate because the details about these are only available to the buyer and seller and are not public.
However, the unstandardized and unregulated nature of these contracts make it more susceptible to a cascading series of defaults. Such risks are usually mitigated by being very careful when choosing the counter-party for the contract. Banks and other financial institutions remain extra careful to avoid any possibility of large-scale risks.
Another risk with forwards is that they are only settled on the settlement date unlike futures. In such a case the institution which originated the contract is exposed to a greater degree of risk in even of non-settlement of contract or default.
Conclusion
While forward contracts are not available easily for the retail investors, they do carry a high amount of risk associated with them. Therefore, if you are not an institutional investor it is recommended to invest in futures contract instead which work very much similar to futures. You should get your risk profile evaluated from a SEBI registered investment advisor before investing in any of the investment instruments to have an idea about your risk bearing capacity.
Happy Trading!
