Forward Contracts Meaning, Features and Advantages
Investing in Stock Market
Future Contracts Meaning
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. On the expiration date, the contract has to be settled by delivery of the asset.
Other contract details like expiration date, price and quantity are negotiated bilaterally by the parties to the contract. On the expiration date, the contract has to be settled by delivery of the asset. The forward contracts are normally traded outside the exchanges.
Forward Contracts Features
The salient features of forward contracts are as given below:
1. They are bilateral contracts and hence exposed to counter-party risk.
2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
3. The contract price is generally not available in public domain.
4. On the expiration date, the contract has to be settled by delivery of the asset.
5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.
Advantages of Forward Contracts
The general benefits of using forward contracts are as follows:
1. Reduction of business risk: A prudent use of forward contract is that it can help to manage or reduce various business risks such as fluctuation in exchange rate, reduction in prices of commodities at low transaction cost.
2. Reduction in financing cost: The innovative use of forward contracts is that is can reduce the financing cost of end-users.
3. Customization of forward contracts: Each forward contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
4. Physical delivery: On the expiration date, the contract has to be settled by delivery of the asset. Assets are physically transferred from the short position to the long position according to the term mentioned in the contract.
5. Profits: Forward contracts can be used to speculate and make profits by assuming certain risks, probably with suitable degrees.
6. Asset management: Forward contracts play an important role in asset management due to their lower transaction costs relative to the spot market instruments.