Meaning : A forward contract is a simple customised contract between to parties to buy or sell an asset at a certain time in future for a certain price agreed today. Forward contracts are over-the-counter traded contracts, means they are not traded in stock exchange. these contracts are generally private contracts between two financial institution or between a financial institution and its corporate client.
Over-the-counter market is a market where sell and purchase of securities and commodities are undertaken between two parties at some specific place through dealers network and not through stock exchange. over-the-counter market is also known as off-trade exchange.
In forward contract one party takes long position and other party takes short position.
Long Position – When a party agrees to buy the asset at a certain specified date for a specified price, it is said to have taken a long position.
Short Position – The other party which agrees to sell the asset on the same date for the same price is known to have taken Short position.
Features of forward contract –
- they are bilateral contract where all details of the contract are negotiated by the parties bilaterally
- it is highly customised contract where each contract is unique in terms of contract size, expiration date, and the asset type and quality.
- it is traded over-the-counter and not through stock exchange.
- the settlement takes place through delivery of the asset on the expiry date.
- it tries to mitigate the price risk but does not eliminate performance risk.
- in forward contract, sometime derivative can be contracted for a combination of underlying assets properly known as synthetic assets.
- forward contracts are more popular in foreign exchange and usually have foreign desk to perform such type of contract.
- in forward contract there is higher chances of counter party risk, which is a serious issue worldwide.