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A forward contracts is an agreement to buy or sell an asset on a specified date for a specified price. In this agreement, one party assumes a long position and agrees to buy the underlying asset on a certain 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. The forward contracts are usually traded outside the exchanges.
The prominent features of forward contracts are:
- They are bilateral contracts and hence exposed to counter party risk.
- Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
- The contract price is generally not available in public domain.
- On the expiration date, the contract has to be settled by delivery of the asset.
- If the party wishes to reverse the contract, it has to compulsorily go to the same
Counter party, which often results in high prices being charged. Having said that, forward contracts in certain markets have become very standardized and foreign exchange is an example. This standardization has reduced transaction costs and increased transactions volume.
Forward contracts are heavily used by hedgers and speculators. For instance, an exporter may be expecting a dollar payment in three months time. In the meantime, he/she is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he/she can lock on to a rate today and reduce his/her uncertainty. In a similar way, an importer who is required to make a dollar payment in three months can reduce his/her exposure to exchange rate fluctuations by buying dollars forward.
A speculator might go long on the forward market instead of the cash market based on information or analysis he has in hand. The speculator will go long on the forward, wait for the price to raise, and then take a reversing transaction to book profits.
