Sunday, January 15, 2017

Forward Contracts - Concept And Example

Forwards are the simplest form of a derivative contract. We can define a forward contract as an agreement between two parties to exchange a specific asset on a specified future date at a predetermined price (forward price). Both the delivery and the payment is made on the specified future date.

The concept of forward contracts can be better understood with the following example.

A Ltd is a manufacturer of Apple juice. It acquires a 1000 kg of Apples from the open market every month. Today is 1st of January and the prevailing market price of Apple is Rs 10 per kg. It however anticipates, owing to deficient production, that the price of Apple would escalate to Rs. 15 per kg in a month's time.

It therefore enters into a contract with a farmer to acquire from him 1000 Kg of Apples at a mutually determined price of Rs. 12 per kg; one month hence.

Therefore on the settlement date of the contract i.e on 1st of February, A ltd makes a payment of Rs. 12000 (1000 kg at Rs. 12 per kg) to the farmer and takes delivery of 1000 Kg of Apples from the farmer.

From the above example, the following features of a forward contract emerge:

1. A forward is a contract - which is entered into today and settled at a future date. 

2. The terms of the contract (including the settlement date and the forward price) are mutually agreed upon by the parties to the contract at the time of entering into the contract. Forward contracts are therefore non-standardised.

3. The parties to the contract are bound to perform the contract on the contract settlement date.

4. There is a counter party risk involved. Counter party risk is the risk that one of the parties to the contract defaults on his/her obligations on the settlement date.

5. The parties can, by mutual agreement, alter the terms of the contract before the contract settlement date. 

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