Forward Contract – Meaning & Features

This is the grandfather of all derivatives. It’s what 17th-century Japanese farmers used for Rice.

1. Definition

"A Forward Contract is an agreement between two parties to buy or sell an asset at a specified point of time in the future at a price agreed upon today."

• Key: It is a custom (private) deal. Not on the stock exchange.

2. Example: The Farmer & Baker

• Scenario:
  • Farmer: Growing Wheat. Fears price will drop below ₹20.
  • Baker: Needs Wheat. Fears price will rise above ₹20.
• The Contract: They meet today and sign a paper:
  • "I (Farmer) will sell 100kg Wheat to you (Baker) on 1st Dec at ₹22."
• Result: Both are locked in.
  • If market price becomes ₹15, Farmer happy (sells at 22).
  • If market price becomes ₹30, Baker happy (buys at 22).

3. Features

1. OTC Nature: Over-The-Counter. It happens between two people (or Bank and Client), not on an Exchange.
2. Customized: You can agree on any amount (e.g., 123.5 kg), any date.
3. Bilateral: Only two parties involved. No Clearing House.
4. Counterparty Risk: If the Farmer runs away, the Baker loses.

4. Exam Notes: Writing the Answer

Question: "Define Forward Contract and state its features." (5 Marks)

Answering Strategy:

1. Definition: "Agreement... future date... fixed prize".
2. Example: Use the Farmer/Baker example.
3. Keywords: "OTC", "Customized", "Default Risk".

Summary

• Simplicity: It is the simplest derivative.
• Risk: But it is the riskiest because there is no guarantee (unlike Futures).

Quiz Time! 🎯

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