When trading in stocks and commodities, there are two types of trades – spot trades and derivatives.
Spot trades are when you buy or sell the security at the prevailing market price. Derivatives, on the other hand, are those that derive their values from security or an asset. These contracts involve buying or selling the assets at a later date at a specified price.
Forward contracts are a type of derivative contract that can be in stocks, commodities or even foreign currency.
Let’s understand what these contracts are and how they work.
Forward contracts are contracts between two parties – the buyers and sellers. Under the contract, a specified asset is agreed to be traded at a later date at a specified price.
For example, you enter into a contract to sell 100 units of a computer to another party after 2 months at Rs. 50,000 per unit. You enter into a forward contract. After 2 months, the buyer would pay you Rs. 50 lakh for the agreed 100 units of computer and settle the contract.
To understand the working of a forward contract, you need to understand the different components of the same. The basic components of a forward contract include the following –
This is the security (stock, commodities, index or currency) that is traded. The value of the forward contract is derived from the value of the underlying asset.
The price at which the contract is agreed to be executed. This price is usually calculated by adding the risk-free rate of return to the market price of the asset.
There are two parties to a forward contract – the buyer and the seller.
The specified date at which the contract is to be executed is called the future date.
Once these components are worked out, the contract is drawn. The trading principle behind a forward contract is simple:
For example, a forward contract is drawn between the buyer and seller for 100 kgs of wheat at Rs. 30/kg. The buyer expects the price of the wheat to rise beyond Rs. 30/kg. If, on the contract execution date, the market price of wheat is Rs. 32/kg, the buyer makes a profit. He can buy 100 kgs at Rs. 30 and then sell them at Rs. 32 thereby making a profit of Rs. 2/kg.
Thus in a forward contract, the buyer and seller have opposing views with respect to the price of the underlying asset. One party expects the price to rise while the other expects it to fall. So at the time of execution, one party makes a gain while the other suffers a loss.
The forward contract can be settled by the actual delivery of the underlying asset or in cash wherein one party pays the differential cash to another.
A forward contract sounds very much like a futures contract but it is not the same. While both are types of derivatives, they are quite different from one another. Here’s how –
|They are not traded on the stock exchange.||They are traded on the exchange|
|It can be customised depending on the needs of the buyer and the seller||Futures are standardized contracts|
|A clearinghouse is not involved||A clearinghouse is involved in the settlement of futures|
|They are settled at a specified date||Futures can be traded whenever the exchange is open|
Forward contracts are traded extensively as they are relevant for both buyers and sellers. If you also want to trade forwards, understand it means and their workings so you can make informed investment decisions.