A forward contract is a financial agreement between two parties to buy or sell an asset, at a future date for a price agreed upon today. Unlike standardized contracts traded on exchanges (like futures), forward contracts are private agreements between two parties. They are typically used to hedge risk or speculate on future price movements.
How Do Forward Contracts Work?
In this contract, one party agrees to buy an asset (like stocks) at a certain price, while the other agrees to sell it. The price is fixed at the time of the contract’s creation. But the transaction will only take place on the agreed-upon future date. The key feature of forward contracts is that they are private agreements. This means the terms (the price and the asset) are flexible. They can also be tailored to meet the needs of both parties involved.
Why Are Forward Contracts Used?
- Hedging Risk: Forward contracts are often used to protect against the risk of price changes. For example, if a company anticipates that the price of a stock it holds will fall, it might enter into a forward contract to sell the stock at a higher price in the future. This locks in a sale price and reduces the risk of losing money due to price fluctuations.
- Speculation: Investors also use forward contracts to bet on the future price movement of stocks. If they believe a stock will rise, they might agree to buy it at a lower price in the future, hoping to sell it for a profit later.
Example of a Forward Contract:
An investor, Ramesh, believes that Stock X, currently priced at $100, will rise in value over the next three months. He enters into a forward contract to buy 100 shares of Stock X at $105 each in three months.
If, in three months, the stock price has risen to $120, Ramesh can buy it at the agreed-upon price of $105. He makes a profit of $15 per share. On the other hand, if the stock price falls to $90, he is still obligated to buy the stock at $105, resulting in a loss.
Advantages and Disadvantages:
Advantages:
- Customization: The terms of a forward contract can be tailored to fit the specific needs of both parties.
- Hedge against price movements: Forward contracts help manage the risk of unexpected price changes.
Disadvantages:
- Counterparty risk: Since forward contracts are private agreements, there’s a risk that one party might not fulfill the contract.
- No liquidity: Forward contracts are not traded on an exchange, so they can’t be easily bought or sold before the contract matures.
Conclusion:
Forward contracts in the stock market are useful tools for investors who want to manage risk or speculate on price movements. They provide certainty about future prices, but they also come with risks, as the market price could move unfavorably. Understanding how these contracts work is essential for anyone looking to use them in the stock market.
– Ketaki Dandekar (Team Arthology)
Read more about Forward Contracts here – https://groww.in/blog/forward-contracts