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In a spot transaction, all the above-mentioned processes of trading, clearing and settlement occur simultaneously. It happens on the ‘spot’, hence having its name as the ‘spot’ market.
For example Amar wants to buy gold and the vendor quotes him Rs. 18,000 per 10 grams. They agree on this price and Amar buys 30 grams of gold. He pays Rs. 54,000, takes the gold and leaves. This is a spot transaction.
If Amar does not pay on the spot and instead wants to pay a month later at the same price, they will agree upon the ‘forward’ price for 30 grams of gold that Amar wants to buy and he leaves.
A month later, he pays the goldsmith Rs. 54,000 and collects his gold. This is a forward contract, a contract by which two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity.
When the forward contract is signed, no money or goods are exchanged. The exchange happens at the agreed future date that is mentioned on the contract. In a forward contract, the process of trading, clearing, and settlement does not happen instantaneously.
A forward contract is the most basic derivative contract. It is a derivative instrument because the price of the contract is derived from the underlying asset.
If the price of the commodity traded becomes more valuable by the end of the contract period, the buyer of the forward is at an advantage as he bought his product at a lower cost. If however the price of the commodity falls at the end of the contract, he would be at a loss because he is buying at the agreed higher price. The vice-verse is application from the seller’s point of view.
