• Let us assume that you are a fruit dealer, and you agree with a farmer to deliver 500 kilos of apples at Rs.100 a kilo, after three months. It is called a forward contract. The specified asset is apples, the specified future date is three months from now, and the price is Rs.100 per kilo. This contract is between a seller and a buyer.

• The contract is to deliver goods or asset at the specified price on a future date, at a fixed price. The buyer and takes delivery of the goods or assets by making payment on the date of delivery.

• These contracts are tailor-made by deciding the quantity, delivery mode, and the time of maturity of the contract.

What will happen when one of the parties to the contract are not willing to oblige?

This kind of risk is always there in a forward contract, and there is no guarantee. The buyer and seller will have to sort it out themselves.

Use of 'forward' contracts in our day to day life.

Forwards contracts can happen in our daily lives without our knowledge. Let us say that the price of gold has been on the rise every year, and you would like to invest in gold coins. As gold coins were not in stock with your jeweler at that time, they promised to deliver the coins within five days. You wanted to purchase them at the rate applicable today. The jeweler agrees to make delivery of the gold coins at that rate, five days later because he did not want to lose the customer. Technically, this is an example of a forward contract.

• You have entered into a forward contract with your jeweler.

• The jeweler is obliged to deliver the gold coins after five days when you pay the agreed price.

• The delivery date, price, size, and any other terms and conditions are made binding by this contact.

• Assuming that it was a written contract, payment is made only at the time of delivery and not earlier.

• Technically, this contract is a ‘Gold forward contract’.

Four important points to note here is that –.

• Here the seller agreed to sell the coins on a future date at a mutually agreed price ON the day of contract. The seller must therefore deliver the gold coins on the future date at the agreed price. The seller here has sold the forward contract.

• Here you buy the coins on a future date at an agreed price. As a buyer, you are to contact the seller five days after the day of the contract and pay the agreed amount. You have bought a forward contract.

• As the contract does not trade on the exchange, it is a private contract, and there is the possibility of counter-party risk.

• Advance payment or margin money is usually not made while agreeing. But it does not prevent you from making advance payments.

What if there is a fall in the price of gold?

If the price of gold were to go down during the five days, then the seller would stand to gain because he sold you the gold coins at a higher price. In the same way, you would gain if the price of gold were to go up. Whatever may be the price of gold after five days, the purchase price confirmed on the day of the agreement is to be executed.

As forward contracts are not regulated, there is the possibility of default from either the seller or buyer if they find the agreement unfavorable.

Going by the above example, after five days, you may not buy the gold coins if the agreed price were to drop. The same is true, if the price were to go up, the dealer may refuse to settle for the price already agreed.

‘Counter-party risk’ is the term used, and are present in forward contracts always.

SETTLEMENT

Anyone of the parties to the contract will stand to benefit depending on the movement of price. Let us now look into the settlement of forward contracts.

Forward contracts are settled “Over the counter” (OTC). Therefore, these contracts are known as OTC contracts. “Over-the-counter” contracts are not through a centralized exchange and refer to the settlements done with a dealer.

The settlement of the contracts happens in two ways at the end of the contract period.

The actual delivery of goods is made when payment is made on the settlement by cash when the parties involved or settling the difference in cash positions.

At the mango farm.

Let us look at a situation where forward contracts are used.

Presently mangoes are being sold at Rs.15000 a ton. Three months from now, a mango farm expects to get a yield of 10,000 tons. The owner of the farm is worried that the price of mangoes could go down at the time of harvest because he expects a bumper harvest of mangoes in other nearby farms as well. So, to eliminate the risk of price going down, he locates a buyer who is prepared to buy the mangoes at Rs. 30000 a ton.

A mango pulp processing company fears that their competitors could buy mangoes in bulk, thus resulting in the mangoes being in short supply that could increase the prices. They cannot change the price of mango pulp because they fear that their sales may go down.

The company cannot change the price and at the same time, maintain its profits at present levels. The two parties agree on a forward price of Rs.30 a Kg.

It is to be delivered three months from now at the time of harvest.

It is only an agreement where payment has not happened. Delivery of 10,000 tons of mangoes to the pulp processing company will take place after three months. At the time of delivery, they do it at a price agreed upon three months ago.

Whether the price of mangoes three months from now is Rs. 3000 a ton or Rs.1500 a ton is irrelevant. The parties involved had predetermined their profits and thereby eliminated the risk of volatility in price.