What is a forward contract?

A forward contract is a privately negotiated agreement between two parties to buy or to sell an asset at a specified price on a future date. Under forward contract, there is an obligation for the buyer to pay for what has been bought and receive delivery thereof as per contract, and for the seller to give delivery of what has been sold and receive payment for the same. It is an investment technique used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In the other words it is a process of hedging to reduce the risk of adverse price movements in an assets.

In foreign exchange market ‘forward contract’ means an exchange agreement between two parties to deliver one currency in exchange for another currency at a forward or future date. These contracts are categorized as ‘Fixed Date Forward Contracts’ and ‘Option Forward Contracts’ based on type of contract. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date. In another arrangement whereby the customer can sell or buy from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange which is known as ‘Option Forward Contract’.

A forward contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments.There are two types of participants in forward-contracts viz. hedgers and speculators. A hedge is a risk management technique used to reduce any substantial losses or gains suffered by an individual or an organization. Hedgers do not usually seek a profit but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying asset. In case of speculators, they essentially place bets on which way prices will go. Speculators therefore take on risk, especially with respect to anticipating future price movements, in the hope of making profit out of the contract. However, Forward contracts tend to attract more hedgers than speculators. Though, forward contract and future contract are similar in nature unlike the ‘Futures’ the forwards are bilateral contracts traded ‘over the counter’ whereas ‘futures’ are traded on organized exchanges.