Disadvantages of Forward Contracts – Default & Liquidity Risks

Forwards are great for customization, but terrible for safety.

1. Key Disadvantages

1. Counterparty Default Risk (Credit Risk)

   • Since there is no Exchange guarantee, if the other party loses money, they might run away.
   • Example: Farmer agrees to sell at ₹20. Market Price becomes ₹50. Farmer refuses to sell. Buyer loses.

2. Liquidity Risk (The "Hotel California" Problem)

   • You can enter, but you can't leave.
   • Once you sign a Forward, you are stuck till expiry. You cannot sell the contract to a third party because it is customized.

3. Lack of Transparency

   • Prices are secret. You might agree to sell at ₹20 only to realize your neighbor sold at ₹25 to the same bank.

2. Diagram: The Risk Structure

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3. Exam Notes: Writing the Answer

Question: "Explain the limitations of Forward Contracts." (5 Marks)

Answering Strategy:

1. Default Risk: This is the #1 point. No Clearing House.
2. No Liquidity: "Cannot exit before maturity".
3. Price Discovery: "Inefficient" because prices are private.

Summary

• Evolution: These disadvantages led to the invention of Futures Contracts, which solved both Default and Liquidity problems.

Quiz Time! 🎯

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