In a Forward contract, one trader agrees to buy and another trader agrees to sell any asset or a security at a pre-agreed specific price on a specific date in the future. The gain or loss depends on the price at that specific date. If the price is more than the pre-agreed transaction price; then the buyer of the contract gains else for the opposite case the seller of the contract gains.
A forward contract is a bilateral contract that requires one trader to buy one asset or security and another trader to sell that security. Here neither of the traders pays any premium nor security deposit to enter into the contract. So the default risk is always there in Forward contract.
The trader in the forward contract which agrees to buy the asset of security is specified to be in Long position and is called simply long. The seller of the same contract is specified to be in Short position and is called simply short.
As there is no security deposit or premium involved in the Forward contract, each trader is exposed to Default risk, where one trader who is losing money may not keep the contractual agreement as promised.
Forward contract can be completed either by delivery of the underlying asset or by cash settlement, where for the later, the trader in profit will receive the profit amount from the trader in loss. The profit will be same as loss.
Let us see the below example to understand the features of Forward contract
Suppose Crude oil is currently trading at USD 100 per barrel. Oil Refiner X wants to buy crude oil after 30 days and Oil producer wants to sell crude oil at the same time.
Because of the volatility in the crude oil price, the trey have got into a forward contract agreement by which Refiner X agrees to buy crude oil from the producer at the rate of USD 105 per barrel after 1 month.
As per the contract the supplier agreed to sell the crude oil price at the rate of USD 105 per barrel after one month, whatever the price may be.
Suppose after one month the price of crude oil rises to USD 110 per barrel.
Because of the forward contract, the supplier Y will sell the crude oil at the pre-agreed price of USD 105 to the refiner X.
Refiner X will gain USD 5 per barrel of crude oil and Supplier will lose the same amount. It’s a zero sum game, where someone’s gain will be other’s loss.
If the crude oil price stays at USD 100 per barrel after one month, the gain loss case will be reversed.
Here anyone of both the traders may not fulfill the agreement after one month, leading to default risk.
Forward contracts are widely used in currency segment to hedge against any potential currency rate movement. Let us see the another example to understand the currency Forward contract
Suppose current INR/USD currency exchange rate is INR 45 per USD and Rupee is expected to appreciate in next one month due to dollar depreciation. For a software exporter rupee appreciation can hurt their margin and profitability badly. To hedge against the same one Indian software company X has initiated a forward agreement to sell dollars at INR 44.5 per USD rate after 3 months with a US exporter company Y.
As per the forward agreement, the company X will be able to sell the dollars at the fixed rate of INR 44.5 per USD after three months whatever the exchange rate will be at that time.
The company Y will buy the USD and pay INR 44.5 per dollar at that time as well.
Suppose after three months the Indian rupee has appreciated much more than expected and touched the rate of INR 43 per USD.
Because of the forward contract, The Company X will be able to sell USD at the rate of INR 44.5 per USD and save INR 1.5 per USD.
At the same time the US exporter Company Y will buy USD at the same rate.
Here because of the loss the US Company Y may not fulfill the agreement after three months, leading to default risk.
This is how the companies and trader can hedge the currency rate and any commodities from any adverse price movements using forward contracts.