A Forward Contract is a legal AGREEMENT between two parties to buy or sell an asset at a specified price on a future date. It is an Over-the-Counter (OTC) contract that is customizable and is settled at a future date. They are commonly used in commodities, currencies, and financial markets.
Table of Contents
Forward Contract – What Is It?
As per IFRS 9 derivatives it is an EFFECTIVE way to manage risk, particularly in volatile markets. They offer a way for businesses to lock in a future price for an asset, which can help to mitigate the risk of price fluctuations.
The TERMS of a forward contract are negotiated between the two parties, and they can be customized to meet the specific needs of the parties involved. The contract will specify the price at which the asset will be bought or sold, the date on which the transaction will occur, and the quantity of the asset involved. The terms of the contract are BINDING, and the parties involved are obligated to fulfill the terms of the contract.
Forward Contract – Practical Example
For example, if a business is planning to buy a large quantity of wheat in six months, it can enter into a forward contract with a supplier to lock in a price for the wheat. This can help the business to avoid the risk of price increases in the future.
Forward Contract – Benefits and Risks
| Benefits | Risks |
|---|---|
| One of the main BENEFITS of forward-contracts is that they are ‘flexible‘ and ‘customizable‘. They can be tailored to meet the needs of the parties involved, which can help to reduce risk and increase certainty. | Flexibility means that there is a higher level of risk involved. Because forward-contracts are NOT traded on a regulated exchange, there is a higher risk of counter-party default. Another risk of forward-contracts is that they are NOT very liquid. Once a contract has been signed, it cannot be easily traded or sold. This can be a disadvantage for parties who need to CHANGE their position in the market or who need to liquidate their assets quickly. |
1. Risk Management Tool
Despite these disadvantages, forward-contracts remain a popular tool for managing risk in financial markets. They are widely used in the commodities market to manage ‘price risk‘, and they are also used by investors to manage ‘currency risk‘.
They are particularly popular in EMERGING markets, where currency risk is often high.
In recent years, there has been an INCREASE in the use of derivative contracts, such as futures and options, which offer similar benefits to forward contracts.
[However, they remain an IMPORTANT tool for managing risk in financial markets.]
The Bottom Line
Forward Contract is a legal AGREEMENT between two parties to buy or sell an asset at a specified price on a future date. They offer a way to manage risk and increase certainty in volatile markets. They are customizable and flexible, but they also come with a higher level of RISK due to the lack of regulation and liquidity. Despite these disadvantages, forward contracts remain an IMPORTANT TOOL for managing risk in financial markets.
Chartered Accountant (Institute of Chartered Accountants of Pakistan)
Bachelor of Accounting Honours (Asia e University, Malaysia)