Stock markets provide traders with the option to trade in the primary market as well as the secondary markets. Primary markets are where the parties directly trade in the securities like shares, debentures, bonds, etc. Secondary markets on the other hand are when the prices of the securities traded are derived from the instruments of the primary market. These markets are also known as derivative markets and include forward contracts, futures contracts, options, and swaps.
Read on to know about forward contracts and the related details of the same.
What is the meaning of forward contracts?
Forward contracts, in simple terms, are an agreement between two parties, the buyer and the seller of the contract to buy or sell an asset or a commodity at an agreed price on the predetermined future date. These assets can be indices, stocks, currencies, and commodities. These contracts are derivative contracts as the price of these contracts is derived from an underlying asset. These contracts are similar to futures contracts, however, there are a few key differences between the two. These contracts are mandatory contracts unlike options contracts and both the parties are obligated to execute them as per the agreed terms on the agreed date.
Read more: What is grey market? Is it regulated by SEBI?
What are the features of forward contracts?
Some of the key features of the forward contracts are highlighted below.
- Forward contracts are not standard contracts like futures contracts and are easily customizable as per the needs of both parties involved.
- These contracts are also known as over-the-counter contracts and are not regulated by SEBI or traded on any exchanges
- These contracts can be settled in either of the following two ways,
- Through physical delivery of the asset or commodities where the buyer gets the possession and has to pay the agreed value for the same
- Through cash settlement where there is no physical delivery but the payment of the net difference (difference between current price and spot price) is made in cash.
How do forward contracts work?
Two parties typically enter into the forward contracts to hedge their market position when they have differing views on the price movement of an asset or a commodity. The buyer assumes the price to go higher and therefore wishes to gain profits by locking the asset or commodities in the current price band. On the other hand, the seller assumes the prices of the asset or the commodity to go down and wants to minimize their losses by locking the current price. On the date of delivery or execution of the forward contracts, the settlement of the contract can be either of the following ways,
- When the prices of the asset or commodity remain the same, in such cases, the contract remains in a no profit no loss situation, and the contract is closed.
- When the spot price is higher than the contract price, the buyer makes a profit as their prediction holds true. They can sell the asset at a higher price and buy it at the contracted price from the seller. The profit in this case is the net difference between the current price and contract price.
- When the spot price is lower than the contract price, the seller is in a profitable situation. They can sell the asset at the agreed higher value under the forward contract and buy the same at a lower value from the open market. The profit for the seller is the differential price between the forward price and the current market price.
What are the limitations of forward contracts?
Forward contracts are an excellent hedging opportunity against market risks. These contracts are easily customizable which makes them more appealing to traders. However, there are a few limitations that traders need to be aware of while dealing with forward contracts. These limitations include,
- Unregulated market
Forward contracts are not regulated by SEBI or any other authority like AMFI (in the case of mutual funds). This increases the risk involved as there is no structured grievance platform for either party to address their issues.
- Risk of default
These instruments are over-the-counter instruments and like any other contract have the risk of default by either of the parties. As the contract is not immediately executed but is scheduled to be executed at a later date, the risk of uncertainty and default is quite high.
What are the differences between forward contracts and futures contracts?
Forward contract and futures contracts are part of the derivative markets and both are contracts to be executed at a later date. However, there are subtle differences between the two which are highlighted below.
| Category | Forwards Contracts | Futures Contracts |
| Meaning | Forwards contract is a contract between two parties to buy and sell the asset or commodity at an agreed price at an agreed future date. | A futures contract is an agreement between buyer and seller to buy and sell the asset at an agreed price in the future |
| Customization | This contract can be customized to suit the needs of the individual buyers and sellers. | These are standard contracts that cannot be customized for individual needs. |
| Regulatory body | These are unregulated markets that are not under the purview of SEBI. | Futures contracts are regulated markets that are under the strict purview of the SEBI |
| Settlement process | These contracts are settled on the agreed future date at the agreed price. | These contracts can be settled at any point after entering the contract on the mark-to-market basis |
| Margin | There is no need for providing an initial margin or maintenance margin under forward contracts | These contracts can be entered by providing initial and maintenance margins. |
| Tradable | These contracts cannot be traded on any exchanges | Futures contracts are traded on recognized stock exchanges and can be settled immediately prior to the expiry date. |
Conclusion
Forward contracts, although not regulated by SEBI, are used quite extensively as a hedging instrument against market risks. These contracts do have a high risk of default and uncertainty but can be used effectively to minimize the losses due to market volatility and ensure an overall profitable portfolio.
FAQs
No. Forward contracts can be executed only at the expiry date of the contract.
Forward contracts are mandatory contracts and neither party has the option to back out of it upon expiration.
Under the forward contract, there are only the buyer and seller without the involvement of any exchange for settlement.
Forward contracts are individual contracts between buyers and sellers and without any regulations from any authority, therefore, the prices of these contracts are not generally available in the public domain.
