Forward Contract


In a forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No money changes hands at the time the deal is signed.
Forward contracting is very valuable in hedging and speculation. The classic hedging application would be that of a wheat farmer forward -selling his harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want to buy bread forward in order to assist production planning without the risk of price fl uctuations. If a speculator has information or analysis which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction making a profi t.
Problems in forward markets
Forward markets worldwide are affl icted by several problems: (a) lack of centralisation of trading, (b) illiquidity, and (c) counterparty risk
In the fi rst two of these, the basic problem is that of too much fl exibility and generality. The forward market is like the real estate market in that any two persons can form contracts against each other. This often makes them design terms of the deal which are very convenient in that specifi c situation for the specifi c parties, but makes the contracts nontradeable if more participants are involved. Also the “phone market” here is unlike the centralisation of price discovery that is obtained on an exchange, resulting in an illiquid market place for forward markets. Counterparty risk in forward markets is a simple idea: when one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic issue: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counter- party risk.
Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, the counterparty risk remains a very real problem.

Friday, 02nd Oct 2015, 09:00:12 AM

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