Types of derivatives 1 – Forward contract.

Let’s catch up with the oldest and the simplest of derivatives.

FORWARD CONTRACTS

In forward contracts, two persons enter into an agreement for purchase and sale of a commodity / financial asset at a specified price at a specified future date. These contracts are generally used by traders to guard against price volatility.

  • For example- You are a trader of fruits. You enter into a contract with a farmer to deliver 1000 kilograms of apples at 100 per kilo, 3 months from now. That’s a forward contract. Here, apples are the specified asset, 100 per kilo is the specified price and 3 months is the specified future date.

So, in short, it is a contract between a buyer and a seller-

  • To deliver some goods / asset at a particular price at a future date, the price being fixed right now. On the delivery date, the buyer pays the price and receives the asset/goods
  • These are tailor made contracts and one can choose the quantity, mode of delivery and time of contract maturity.

What if one party to the contract does not oblige?

That risk is always present. There is no performance guarantee in a forward contract. It’s up to the buyer and the seller to fight it out!

FORWARDS IN OUR DAILY LIVES..

Forwards are part of our daily lives unknowingly. Imagine this – Gold prices are rising every year and you want to invest in Gold coins. You go to a jeweler but since gold coins are out of stock, they say that it would take 5 days to deliver. But you want it at today’s rate. The jeweler , not wanting to lose a customer agrees to deliver gold coins at today’s rate, 5 days later. Technically speaking, this is a forward contract.

  • You and the jeweller has entered into a forward contract
  • The jeweler is  obligated to give you gold coins 5 days later when you bring the agreed amount of money.
  • The price , size , delivery date and any other terms and conditions are already locked in through this contact.
  • Payment is made only on delivery-not before that.  Let’s also assume that this was a written contract.
  • Technically this contract can be called as a  ‘Gold forward contract’.

Four important points to note here is that –

  • The seller sold the forward contract. Seller has agreed to sell the coin in the future at a price agreed mutually ON the date of contract. So the seller must deliver the Gold coin in the future at the agreed upon price.
  • You bought a forward contract. You buy the coin in the future at a set price. You are supposed to contact the seller after 5 days from today and must deliver the promised money.
  • The contract is not Exchange traded. It’s a private contract. Hence, counter party risk is present.
  • Margin money (advance payment) is generally not made at the time of entering into agreement. However, there is no hard and fst rule that no payment should be made. If both the parties are ok with making an advance payment, they can.

WHAT WOULD HAPPEN IF THE GOLD PRICE FALL?

Then, the seller would be happy since he sold Gold coin to you for a higher price! Conversely, you would stand to gain should the Gold prices go up. The price of Gold after 5 days is irrelevant. The purchase price was ‘locked’ and the deal has to be executed at the rate agreed previously.

Since forward contracts are not properly regulated, either the buyer or the seller can default in performing his part, should circumstances be unfavorable to him.

To continue the above example – You may not turn up after 5 days to buy the gold coin at the agreed rate if the price drops. Or, if the price went up, it’s not necessary that the dealer would settle for the previously agreed price.

The jargon for this is ‘counter party risk’. It’s always present in forward contracts.

SETTLEMENT

So, finally, one of the parties to the contract stands to gain depending on the price movement.  Now the next question is – how is a forward contract settled?

Forward contracts are usually settled OTC (Over the counter). Hence these are also called OTC contracts. The phrase “over-the-counter” refers to any settlement process via a dealer network and not through a centralized exchange.

The settlement of the contract occurs at the end of the contract. The contract can be settled in two ways-

One, actual delivery of the goods upon payment. Second, cash settlement- The buyer and the seller would simply exchange the difference in the associated cash positions.

AT THE ORCHARDS.

Here’s a realistic scenario where forward contracts are used.




Oranges sell at Rs 2500 a ton right now.  An orchard is expected to yield 10,000 tons of oranges 3 months from now. The orchard owner however fears that the price of oranges would come down by then, because he expects excess supply of oranges from different orchards to the market. The only way for him to eliminate this risk is to find a buyer who is ready to buy these oranges at 2500 per ton.

At the same time, an orange juice company fears that its competitors may buy in bulk and as a result the oranges may be in short supply and so the prices may go up. They can’t change the price of orange juice because they fear if that’s done the sales may drop. They need to maintain the cost and profit at the present rate.

So, these two parties agree today on a forward price of Rs 50 per Kg, for delivery 3 months from now when the crop is harvested. It just an agreement. No payment is made. In 3 months, 10,000 tons of oranges should be delivered to the juice company.When they do it, they can take the price agreed 3 months back.

The price of oranges 3 months hence could be Rs 3000 per ton or Rs 2000 per ton but, that price is irrelevant. Both the parties have already predetermined their profits and have eliminated the risk of price volatility and can plan ahead.

I Hope you are clear with forwards. We will discuss futures in our next article

Till then…

Have a nice day.

You may like these posts:

  1. Introduction to Derivatives.
  2. Dividends and relevant dates
  3. Keep an eye on brokerage costs.

10 Responses to “Types of derivatives 1 – Forward contract.”

Gopinath M

December 14, 2011 at 10:48 am

Excellent Article victor . I like the way you have explained it..Thanks for your efforts..Hope to see more post from your side..

thanks..

RITESH

April 2, 2012 at 3:04 pm

VERY GOOD ARTICLE SIR

Ahmed

May 12, 2012 at 6:44 pm

Well explained :)

GEETHA

August 19, 2012 at 9:33 pm

well explained sir..it was too gud…..

J Victor

August 19, 2012 at 9:45 pm

thankyou:)

VEERA

January 7, 2013 at 6:44 pm

WHAT HAPPENS WHEN A FORWARD CONTRACT IS NOT RENEWED? DOES IT AUTOMATICALLY EXPIRE ON THE SETTLEMENT DATE?

thapelo

August 22, 2013 at 2:12 am

cannot believe i just found this articles this year. thanx a lot, you are my hero!

rajinder kapoor

August 17, 2014 at 5:35 am

wonderfully explained tn simple language !

nayan patel

April 18, 2016 at 1:22 pm

Excellent and easy way to make us understand this topic. really very helpful.

J Victor

April 25, 2016 at 8:19 am

thankyou , Nayan !

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