How Do Forward Contracts Work?

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The beauty of the stock market is that it offers traders and investors many ways to invest. Traders and investors can make use of various investment methods when they wish to invest in different assets like, say, stocks. One way to go about investment in the stock market is via the route of forward contracts. These may be tailor-made and fall within the category of derivatives contracts. They are customisable as they can be made according to a particular commodity, delivery date, and amount. Before you dive deeper into how these versatile contracts work, you should gain an understanding of what they are.

Highlights

  • Understanding Forward Contracts
  • Main Features of Forward Contracts
  • How do Forward Contracts work?
  • Uses of Forward Contracts
  • Risks Associated with Forward Contracts

Understanding Forward Contracts

A forward contract is an agreement that is undertaken between two parties to purchase or sell an asset at a specific future date for a fixed price that is agreed upon when the contract is entered into. Used primarily to hedge against the risk of price fluctuations of an asset, this contract proved to be useful to traders and investors. 

Main Features of Forward Contracts

  • Privately Traded

Forward contracts are contracts that are privately traded over-the-counter (OTC). This means that they are privately negotiated between the two signing parties and are not traded on an exchange like regular stocks or other exchange-related assets.

  • Customisable Contracts

The terms of forward contracts are very flexible and can be tailored to suit the requirements of both parties that enter the contract. Flexibility includes the quantity, price, and delivery date of the asset in question.

  • No Initial Cost

While entering a forward contract, there is no initial cost or any premium that you have to bear. When the contract is ultimately settled, the profit or the loss is realised.

How do Forward Contracts work?

To know how forward contracts work, you must grasp certain features of these unique contracts. The features also form the steps you must take to enter forward contracts. Here are some aspects and factors that give you an idea of how forward contracts work: 

  • Establishing an Agreement

Two parties formulate a forward contract and agree to purchase or sell a specific underlying asset at a particular future date for a fixed price agreed upon when the contract is signed. The underlying asset may be anything from stocks to commodities and other securities. 

  • Obligation by Both Parties

Once the contract is sealed, both the agreeing parties are obligated to fulfil the terms mentioned in the contract. The buyer has to purchase the asset at the price that is agreed on and the seller has to sell the asset at the price that is fixed by the contract.

  • Settlement of Forward Contracts

Forward contracts have a date of expiry. At the date of expiry of the contract, the contract may be settled in two ways. This can happen with the physical delivery of the asset or via a cash settlement. In a physical delivery, the seller must deliver the underlying asset to the purchaser, and the buyer must pay the price agreed upon. In a cash settlement, both parties settle the forward contract by paying the difference between the spot price and the forward price at the time of settlement.

Uses of Forward Contracts

You may wonder why investors get into forward contracts at all. Why not just buy assets directly and sell them for a potential profit? There are some key uses of forward contracts and these are listed below: 

  • Hedging

Forward contracts are frequently used for the purpose of hedging. For instance, a company that knows it will require a specific amount of a commodity in the future may enter a forward contract to set a price today. In this way, the risk of price fluctuations is reduced.    

  • Speculation Purposes

Traders and investors can also use forward contracts for speculation. If a trader or investor believes that the price of an asset will shift in a particular direction, they can easily use a forward contract to potentially make a profit from the movement in the price.

Risks Associated with Forward Contracts

While forward contracts are useful for speculation and hedging, they are also associated with risks. These include:

  • Counterparty Risk

Since forward contracts are actually private agreements, there is always the potential risk of one party defaulting on their obligation.

  • Market Risk

The market price of the forward contract’s underlying asset can fluctuate in an unfavourable direction, leading to potential losses.

  • Liquidity Risk

Forward contracts are less liquid compared to derivative instruments like futures contracts, in which you may find it difficult to exit positions.

The Last Word on Forward Contracts

Forward contracts are the main financial tools to effectively manage risk and speculate on price movements. Nonetheless, they are also associated with risks and some challenges. As with any financial investment instrument, it's crucial to understand the workings of forward contracts before you enter them.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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