Meaning of Forwards (or Forward Contracts)
A forward contract (or simply forward) is the simplest and oldest form of derivatives A forward is an agreement between two parties to buy or sell an asset at a future date at a price agreed today. So, in forward contracts, the date, the price and the quantity are decided at the time of entering into contract. But the contract is implemented in future on the agreedndate. Suppose a shopkeeper agrees to sell you a particular model and brand of television set after one month from now at a price of, say, Rs. 1,00,000. You agree to the offer. This means that you have entered into a forward contract with the shopkeeper. You are obliged to make payment of Rs. 1,00,000 and take delivery of the television set after one month from today. Similarly the shopkeeper is obliged to deliver the particular model and brand of television set to you and receive Rs. 1,00,000. When you agree to buy an asset in future, you actually buy a forward contract. The shopkeeper sells the forward contract. Suppose after one month the price of the television set increases to Rs. 1,10,000. But you have to pay only the agreed price (i.e., Rs. 1,00,000). Suppose the price falls to Rs. 95,000. Then you have to pay the agreed price of Rs. 1,00,000. The agreed price is called forward price. If the actual spot price is higher than the forward price, the buyer is in an advantageous position because he gets the asset at a cheaper price than the prevailing market price. The seller is in a disadvantageous position because he has to deliver the asset at a price which is lower than the prevailing market price. If the spot price is lower than the forward price, the buyer would be at a disadvantage and the seller would benefit. Currencies and in agricultural products.
Example of a Forward Contact
A wheat farmer has planted a crop that is expected to yield 80 quintals. To eliminate the risk of fall in the price of wheat, before the harvest the farmer enters into a forward contract, on 1st July 2019, with a trader to sell the 80 quintals of wheat at 1,300 per quintal after five months. The current price is ₹ 1,200 per quintal. No money changes hands now. Suppose the market price of wheat is 1,100 per quintal on 1st December 2019. On this date the farmer delivers the 80 quintals of wheat to the trader in exchange for 1,04,000 (i.e., 1,300 x 80). This price, i.e., 1,300 is fixed and does not depend upon the spot price of wheat at the time of delivery and payment (i.e., 1,100).
At the time of entering into contract, the farmer did not know what exactly the price of
wheat would be after five months. Here the farmer gets a gain of 200 per quintal because the market price on 1st December 2019 is 1,100 per quintal. If he had not entered into forward contract, he would get only 88,000 (i.e., 1,100 x 80). The total gain is 16,000 (1,04,000 -88,000 or 200 x 80). Thus, by entering into forward contract the farmer could eliminate the fall in the price of wheat.
Terms used in Forwards
- Underlying asset : This refers to the asset on which the forward contract is made. The various underlying assets are equity shares, stock indices, commodity, currency, interest rate etc.
- Long position : The party that agrees to buy an underlying asset in a future date is said to have a long position. In the above example, the trader is said to hold a long position.
- Short position : The party that agrees to sell an underlying asset in future date is said to have a short position. In the above example, the farmer is said to hold a short position.
- Spot price : It is the price of the underlying asset for buying and selling at the spot time or immediately. In the above example, the spot price of wheat is 1,200 per quintal.
- Contract price/Delivery price : The price at which the forward contract is settled on expiration is said to be contract price or delivery price or forward price. In the above example, the contract or delivery price is ₹1,300.
- Expiration date : This is the date on which the formal contract expires. In the above example, the expiration date is 1st December 2019.
Site Title 