FORWARD CONTRACTS Homework Help

FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on 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 ascertain 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. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. Forward contracts are normally traded outside stock exchanges. They are popular on the Over the Counter (OTC) market. The salient features of forward contracts are as follows: (i) They are bilateral contracts and, hence, exposed to counterparts risk; (ii) Each contract is customer designed and, hence, its unique to terms of contract size, expiration date and the asset type and quality; (iii) The contract price is generally not available in public domain; (iv) On the expiration date, the contract has to be settled by delivery of the asset and (v) If a party wishes to reverse the contract, it has to compulsorily go to the same counterparts, which often results in a high price being charged. However, forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction costs and increasing transaction volume. This process of standardization reaches its limit in the organised futures market.

Forward contracts are very useful in hedging and speculation. A classic hedging application could be that of an exporter who expects to receive payment in dollars, three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on a rate today and reduce his certainty. Similarly, an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, he can go along on the forward market instead of the cash mark. The speculator would go long on the forward wait for the price to rise and then take a revers transaction to book profits. Speculators may well be required to deposit a margin up. However, this is generally a relatively small proportion of the value of the assets underlying forward contract. The use of forward markets here supplies leverage to the speculator.

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