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How do Forward Contracts Work and How to use them?

25 March 2022
4 minutes

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.

What are forward contracts?

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. 

How do forward contracts work?

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 –

  • The underlying asset

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 forward price

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.

  • Contracting parties

There are two parties to a forward contract – the buyer and the seller.

  • Future date

The specified date at which the contract is to be executed is called the future date. 

Trading principal of a Forward contract

Once these components are worked out, the contract is drawn. The trading principle behind a forward contract is simple:

  • The buyer believes that the future price of the underlying asset would increase in future. That is why he enters the contract at the forward price which is lower than the expected price of the asset in future. If his predictions come true, he can buy the asset at a lower rate. And then sell it at a higher rate to make a profit.

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.

  • The seller, on the other hand, believes the price of the asset to fall at a later date. That is why, for security, he locks in a higher price to sell the asset. If the seller’s prediction does come true and the price falls, the seller would not make a loss since he locked in a higher price when entering into the forward contract.

For example, in the aforementioned instance, the seller expects the price of wheat to fall to Rs. 28/kg. If it happens, the seller would stand to make a gain of Rs. 2/kg as he would be able to sell his wheat at a price higher than the market price. 

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. 

Difference Between Forward and Future Contract

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 –

Forwards 

Futures 

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

Takeaway

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.

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