What is a forward contract? Meaning,type & best example 2021

You must have heard about futures and Options contracts in the stock market, but many people don’t know what is a forward contract. This type of contract is completely different from Future contacts. Let’s discuss the meaning of forward contact with examples and the difference between future and forward contract.

What is a forward contract?

A forward contract is a specific agreement between two entities to purchase or sell an instrument at a predetermined price at a later period. A forward contract can be used for hedging or speculation, however because of its non-standardized character, it’s best for hedging.

Forward contracts can be personalized to a particular product, quantity, and delivery date. Forward contracts are classified over-the-counter (OTC) transactions because they are not traded on a centralised exchange.

When compared to contracts that are marked-to-market on a regular basis, financial institutions who begin forward contracts have a higher level of settlement and default exposure.

Example

After knowing what is a forward contract, let’s understand it with the preceding forward contract scenario. Suppose an agricultural producer has 2 million bushels of corn to sell in 6 months and is worried regarding a possible drop in corn prices.

As a result, it engages into a forward contract with its financial institution to sell 2 million bushels of corn for INR 5.60 per bushel in six months, with a cash settlement.

Possibilities

1. The price per bushel is exactly the same at INR 5.60. The producer and the financial institution owe each other no money in this situation, and the contract is closed.
2. It is more expensive than the contract price, which is around INR 6 per bushel. The gap between the current spot price and the agreed rate of INR 5.60 owes the producer INR 0.8 million to the institution.
3. It’s less than the contract price of INR 4.80 per bushel, for illustration. The producer will receive INR 1.6 million from the financial institution, which is the difference between the negotiated rate of INR 5.60 and the actual spot price.

Types of Forward Contract

There are majorly seven types of Forward contracts existing in the market. These are:

1. Window Forwards
2. Long-Dated Forwards
3. Non-Deliverable Forwards (NDFs)
4. Flexible Forward
5. Closed Outright Forward
6. Fixed Date Forward Contracts
7. Option Forward Contract

Originally published at https://profitmust.com on October 13, 2021.