FORWARD CONTRACT AND ITS FEATURE

QUESTION Explain Forward Contracts and its features.      OR

        Write note on Forward Contracts.

Ans.A) FORWARD CONTRACTS :-

Forwards are the oldest of all derivatives. It is an agreement between two parties to buy or sell an asset at a certain date in future at a predetermined price. The promised asset may be currency, commodity, instrument like shares / debentures etc.

Forward contracts are normally traded outside stock exchanges. They are popular on the over the counter market. In a forward contract, the party who promises to buy the specified asset at an agreed price at a future date is said to be in the ‘long position’ and party who promises to sell is said to be in ‘short position’. Thus, long position and short position takes the form of buy and sell in a forward contract.

For Eg :- On October 4, 2010, Mr. Naitik agrees to buy a certain asset on February 4, 2011 for Rs. 1 lakh from Mr. Aniket. This is a forward contract where Mr. Naitik has to pay Rs.1 lakh to Mr. Aniket on February 4 and Mr. Aniket has to supply the asset.

B.   FEATURES OF FORWARD CONTRACT :-

1.    Bilateral Contract :-

Forward contract is a bilateral contract between a buyer and a seller hence it is subject to counter-party risk.

2.    Over The Counter Trading (OTC)

Forward contracts are private contracts hence traded over the counter and not in exchanges. The contract can be modified as per the requirements of parties.

3.    Custom Designed :-

Forward contract is a custom designed contract between two parties. It contains features in terms of size of contract, date of expiry, type and quality of asset etc.

4.    Physical Delivery

There is no physical delivery of assets at the time of entering the contract. Physical delivery takes place only on expiry date.

5.    Settlement At Maturity

Money is exchanged only on the maturity as stated in the contract. The asset must be delivered on maturity date on receipt of payment.

6.    Need For Intermediary

Mostly parties enter into a forward contract with the help of some intermediary. It can be a bank or financial institution or any other party.

C.   LIMITATIONS QF FORWARD CONTRACTS

1.    Since these contracts are customised, they are non-tradable.

2.     There is counter party risk. Default by any one party puts another party in trouble.