What is a forward contract and know it features with example

In the world of finance, prices rarely stay still. Currency rates fluctuate, commodity prices rise and fall, and market conditions can shift overnight. That’s where forward contracts come in. These are private agreements between two parties to buy or sell an asset at a fixed price on a future date.

Forward contracts are private over-the-counter agreements between two parties and unlike other derivatives, they are not traded on stock exchanges.

• Table of contents

• What are forward contracts?
• Understanding forward contracts
• Features of forward contracts
• Understanding a forward contract with an example
• Applications of forward contracts
• Trading principle of a forward contract
• Mechanics of forward contracts
• Difference between forward contract and future contract

What are forward contracts?

To explain it in simple terms, a forward contract is an agreement between two parties to buy or sell something at a fixed price on a future date. The price is decided today, even though the actual exchange happens later.

Take the common example of booking a hotel room several months before your holiday. You have the option of locking the price now to avoid paying more later. A forward contract works in a similar way.

Understanding forward contracts

Let’s simplify the forward contract definition even more clearly:

• Two parties agree today about buying or selling something. This commodity could be anything like gold, oil, or currency.
• Both parties agree on the price today but complete the actual deal later.
• Doing this helps both parties avoid uncertainty about price changes in the future.

In the world of trading and investing, forward contracts help people manage future price risks. They can help a seller lock in a lower price or

Features of forward contracts

Let’s look at some of the key features of forward contracts:

• Customised agreements:
  Each contract is tailored to specific needs, like quantity, price, and date.
• No upfront payment:
  Usually, no money changes hands when the contract is signed.
• Fixed price:
  The agreed price stays fixed no matter how prices change later.
• Private contracts:
  These agreements are not traded publicly, so the details remain private.
• Obligation to honour:
  Both parties must complete the contract on the decided date.

Read Also: Futures and options trading: Definition and types of F&O

Understanding a forward contract with an example

Let’s clearly understand forward contracts with an easy example:

• Suppose Rahul, a farmer, grows wheat and expects 100 kilograms of harvest in six months.
• Currently, wheat sells at Rs. 20 per kg, but Rahul worries prices might drop.
• He meets Anand, a buyer who needs wheat after six months.
• They both enter a forward contract at Rs. 20 per kg for 100 kg wheat, payable six months later.

Two things can happen:

• If prices fall to Rs.15 after six months:
  • Rahul is happy as he's selling at Rs. 20, avoiding loss.
  • Anand pays Rs. 20, slightly more than the market price, but has the assurance of supply.
• If prices rise to Rs.25:
  • Anand is happy because he's paying Rs. 20, less than the market price.
  • Rahul earns Rs. 20, slightly less than market, but guaranteed earlier.

This is a clear example of a forward contract benefiting both sides by reducing risk.

Applications of forward contracts

Forward contracts have many simple, practical uses in various fields. Let’s look at some of them:

1. Farming and agriculture

• Farmers lock in prices for their crops early.
• Helps avoid losing money if prices fall later.

2. Currency exchange

• Companies fix currency exchange rates today for future payments.
• Prevents losses from unexpected changes in exchange rates.

3. Commodity trading

• Traders fix prices for goods like gold, oil, or cotton today.
• Protects from price rises or drops in future.

4. Interest rates

• Borrowers lock in future interest rates.
• Provides clear certainty about future loan costs.

Read Also: Stock Market Trading: Meaning, Types, and Historical Context

Trading principle of a forward contract

Trading forward contracts is straightforward:

• Two parties meet and agree on terms that include price, quantity and date.
• The contract is customised for their exact needs.
• Both parties must complete their side of the deal on the agreed future date.
• The agreed price doesn't change, no matter what happens to market prices later.

This simplicity makes forward contracts very attractive to traders and businesses.

Mechanics of forward contracts

Here’s clearly how forward contracts work step-by-step:

• Step 1: Buyer and seller agree today on:
  • Price
  • Quantity
  • Future date of exchange
• Step 2: Both parties sign the agreement privately.
• Step 3: No immediate payment required (in most cases).
• Step 4: On the agreed future date:
  • The seller delivers the goods (or currency).
  • The buyer pays the agreed fixed price.

Difference between forward contract and future contract

It is common for people to get confused between forwards and futures. Let's understand the differences between the two:

To summarise the key differences, forward contracts are private and customised, while futures are standardised and traded publicly.

Read Also: Forward vs Futures Contracts: Key Differences and Examples

Conclusion

Forward contracts offer a practical way to potentially hedge against future price uncertainties by allowing individuals and businesses to fix prices in advance. With their customised nature, these agreements can be tailored specifically to the needs of the involved parties. While they can reduce risk, forward contracts also carry potential drawbacks, such as the possibility of one party failing to fulfil their promise. However, their simplicity and usefulness in various sectors, including agriculture, commodities, currencies, and interest rates, make forward contracts an important financial tool for reducing uncertainty and ensuring stability in transactions.

FAQs

What is a forward contract with an example?

A forward contract is an agreement to buy or sell something in the future at a fixed price agreed today. For example, agreeing today to buy gold at Rs. 5,000 per gram after three months, regardless of its market price later.

What is the difference between forward and futures contracts?

Forward contracts are private, customised agreements between two parties, whereas futures contracts are standardised and traded publicly on stock exchanges.

What is the difference between a forward contract and hedging?

A forward contract is a specific financial tool. Hedging is a broader strategy of protecting against risks, which can include using forward contracts among other tools.

Who uses forward contracts?

Forward contracts are used by a range of market participants, including farmers, businesses, and investors, to manage risk or speculate on future price movements. Farmers lock in prices for their crops to protect against price declines, while companies use them to hedge against currency fluctuations or secure future costs. Financial institutions and commodity traders use forward contracts for both risk management and speculation. Essentially, they offer a way to mitigate exposure to market volatility.