Forward Contracts

A forward contract is a customized contract between two parties to purchase or sell an underlying asset in time and at a price agreed upon today (known as the forward price). It is a type of derivative contract between two parties.

The parties to the contract agree to the delivery of the asset in future which can be customised as per the requirement of the parties. They are usually for long term and traded over the counter on fexible terms. The price remains fixed till expiry. It is widely used for risk management and speculation.

• A forward contract is established between two parties to purchase or sell an underlying asset at a prearranged price in the future, known as the forward price, which is agreed upon at the contract's inception.
• In this arrangement, the purchaser is termed the "long" and anticipates a price increase, while the seller, known as the "short," expects a price decrease.
• Parties engaging in a forward contract must make an initial determination whether the settlement will occur through physical delivery or cash settlement. This decision remains fixed and cannot be altered subsequently.

Forward contacts derivatives are a type of agreement in the derivative market where the buyer and seller agree to buy or sell an underlying asset at a price previously agreed upon between them. The delivery or the expiration date is also specified beforehand.

The buyer of the contract is called the long. The buyer bets that the price will go up. The seller of the contract is called the short. The seller bets that the price will go down.

In this, no money changes hands until the settlement date. The forward price is set, so neither party needs to pay any money at contract initiation.

They are subject to default risk regardless of their methods of settlement. Only the party that owns the greater amount can default in both deliverable and cash-settled forward prices.

The Long party or the buyer gains if the asset price is higher than the forward price during forward contracts accounting because they are able to purchase the asset at a price lower than the market price using the contract.

The opposite happens in case of the seller or the one who goes short. Short gains if the asset price is less than the forward price. Now they can sell the undelying asset at a price that is higher than the market price.

Neither party in forward contacts derivatives pays anything at contract initiation.

The various types of the contract are as follows:

Commodity contract – Here physical commodities are delivered, which include metals, oil, agricultural products or any other type of raw materials. Traders use it to manage price fluctuations in the commodity market.

Currency contract – The currency forward contracts involves currency exchange at a future date and at a predetermined exchange rate. The currency forward agreement are commonly used in international trade to manage risk in foreign exchange.

Interest rate contract – This contract is based on interest payment at a future date. Individual investors or businesses use it to manage interest rate risk in order to lock the rate and hedge against interest rate fluctuations.

Equity contract – They involve future delivery of stocks at fixed price and can be used for hedging purpose to control the stock price volatility and also for speculation of future price movement.

Index contract- They are based on index performance and allow investors to gain access to the broader market for investment.

Real estate contact – They deal with real estate to manage price fluctuation of property and hedge against it.

Freight contract – Such contracts involve future delivery of shipping service. They are very common among shipping companies, exporters and importers to manage volatility of freight rate.

The forward contracts accounting an the calculation of its value is explained below in details.

At time t = 0, the long and the short agree that the short will deliver the asset to the long at time T for a price of F0 (T).

F0 (T) is the forward price. If the underlying price is ST at time T, the long is obligated to pay F0 (T) to the short.

Value of the contract to the Long at expiration = ST – F0 (T).

Value of the contract to the Short at expiration = F0 (T) – ST.

When a forward contract expires, it can be settled in two ways:

#1 - Physical Delivery: In a physical delivery settlement, the long pay the agreed-upon price to the short and receive the underlying asset from the short.

#2 - Cash Settlement: In cash settlement, the buyer (seller) receives the difference between the market price and the agreed-upon price if the market price is higher (lower) than the agreed-upon price on the settlement date.

• Cash-settled contracts are more commonly used when delivery is impractical, e.g., in forwarding contracts on a stock index, it would be impractical for short of delivering to the long a portfolio containing each of the stocks in the stock index proportionate to its weighting in the index.
• The cash-settled forward price is also known as non-deliverable forwards, i.e., NDFs.

The pricing model used to calculate forward prices makes the following assumptions:

• No transaction costs or short-sale restrictions.
• Same tax rates on all net profits.
• Borrowing and lending at the risk-free rate.
• Arbitrage opportunities are exploited as they arise.

For the development of a forward pricing model, we will use the following notation:

• T = time to maturity (in years) of the forward contract.
• S0 = underlying asset price today (t = 0).
• F0 = forward price today.
• r = continuously compounded risk-free annual rate.

The forward price may be written as:

Formula #1

F0 = S0exp(rT)

The right-hand side of Equation 1 is the cost of borrowing funds for the underlying asset and carrying it forward to time T. Equation 1 states that this cost must equal the forward price. If F0> S0.exp(rT), arbitrageurs will profit by selling the forward and buying the asset with borrowed funds. If F0< S0.exp(rT), arbitrageurs will profit by selling the asset, lending out the proceeds, and buying the forward. Hence, equality in the formula must hold. Note that this model assumes perfect markets.

Formula #2 (Forward Price with Carrying Costs)

If the underlying pays a known amount of cash over the life of the forward contract, a simple adjustment is made to Equation 1. Since the contract owner does not receive any cash flows from the underlying asset between contract origination and delivery, the present value of these cash flows must be deducted from the spot price when calculating the forward price. This is most easily seen when the underlying asset makes a periodic payment. We let/represent the present cash flow value over T years. Formula 1 then becomes:

F0 = (S0 - I) exp(rT)

Formula #3 (Effect of Known Dividend)

When the underlying asset for a forward contract pays a dividend, we assume that the dividend is paid continuously. Letting q represent the continuously compounded dividend yield paid by the underlying asset expressed on a per annum basis, Formula 1 becomes:

F0 = S0 exp(r-q)T

Suppose we have an asset currently worth $1,000. Calculate the price of a 6-month forward contract on this asset. The current continuously compounded rate is 4% for all maturities.

F0 = $l,OOO.exp(0.04*0.5) = $1,020.20.

Example#2

Suppose there are two parties; one is a farmer who has to sell fruits, and another is a buyer. Both agree that after 4 months when the fruits are ripe, the farmer will sell 10 kgs of apples to the customers at $ 4/kg. After four months, the market price of apples fell to $ 3/kg. But as per the agreed forward contract, the buyer is bound to pay $4/kg. This is illustrated in the diagram below.

Example #3

This type of contact has been in the news when the Bombay High Court made it a rule in the financial market that the Share Purchase Agreement (SPA), which allows the purchaser of shares to request the seller to opt for share repurchase in case of any adverse situation or contingency, does not constitute it to be a forward contact in any manner.

Some of the advantages are as follows:

• They can be matched with the exposure period and the exposure cash size.
• It provides a complete hedge. They help in mitigating the price fluctuations of the underlying asset contributing to forward contracts hedging and also used for speculative purpose to evaluate price movement.
• They are over-the-counter products. . They are not standard products and not regulated by exchanges. They allow a lot of flexibility  of terms but comes with risk.
• Using forward products provides price protection since the price remains fixed till the end of the term.
• They are easy to understand. . Investors can easily interpret and use them as per their own terms and condition fixed. For that reason, they are very common in the financial market.

Some of the disadvantages are as follows:

• Capital binding is required. Before settlement, there are no intermediate cash flows.
• There is an obligation to fulfill the contract from both the buyer and the seller side at the agreed terms on the date specified as per the contract terms.
• It is subject to default risk. This counterparty default risk means one party may default in their obligation.  
• Contracts can be difficult to cancel. Once made, due to their unique terms and condition, trading over the counter without organised exchange makes forward contracts hedging difficult to cancel easily.
• Finding a counterparty may be difficult.

• Liquidity risk exists in the process.

Both the above are two different types of derivative instruments used in the financial market. But their differences are as follows:

• The former is a customised agreement between the buyer and seller whereas the latter is a standardized agreement.
• The former is traded over the counter and the terms are negotiated privately among the parties as per their own requirements with the help of brokers. But the latter is traded in organised exchanges.
• The former may face the risk of  default from the parties since there is no central clearing house to guarantee the entire transaction. But in case of the latter, the exchange acts as a clearing house to guarantee the contract settlement.
• The forward contact does not involve payment of any initial margin or fees but the settlement terms are agreed between parties. However futures contract involve initial margin deposit.
• The terms of the forward contact offer greater flexibility compared to futures and meets the particular needs of the participants. The futures have terms that are predetermined, thus limiting its customization.
• The former is privately negotiated, limiting its liquidity level and restricting exit in case of requirement. However, forwards are more liquid due to their standard terms and conditions. They can be traded at the market price very easily.
• For the former, the clearing and settlement process occurs on the delivery date or expiration date, when the net loss or gain is settled between parties. But for the latter, there is daily settlement called mark to market and gain and losses are settled on a day to day basis.

Thus, both the above contacts play significant roles on the financial market.

This has been a guide to what are Forward Contracts. We explain differences with futures along with example, types, value, advantages & disadvantages. We also discuss the advantages and disadvantages. You can learn more about accounting from the following articles –

• Cost-Plus Contract Types
• The formula of Forward Rate
• Forwards vs. Futures
• Commodity Derivatives