This article has been written by Oishika Banerji of Amity Law School, Kolkata. This article provides a detailed analysis of a forward contract which is a tailored agreement between two parties to acquire or sell an item at a predetermined price at a later period.
It has been published by Rachit Garg.
Table of Contents
Introduction
A forward contract is a contract between two parties to acquire or sell an item at a certain price at a future date. This is a more complicated investing technique that may not be suitable for the average investor. Put in another way, a forward contract is an agreement between the buyer and seller to buy or sell an underlying asset at a price they both agree on at a future date. The forward price is the name given to this pricing. The risk-free rate and the spot price are used to compute this pricing. The former refers to the current market value of an asset. The risk-free rate is the rate of return on an investment that assumes there is no risk. The buyer takes a long position in a forward contract, while the seller has a short one. Forward contracts are designed so that the parties involved can manage volatility by locking in pricing for the underlying assets. In that sense, a forward contract is a form of risk management.
What is a forward contract
A forward contract is a tailored agreement between two parties to acquire or sell an item at a predetermined price at a later period. A forward contract can be used for hedging or speculation, but because of its non-standardised character, it’s best for hedging. Forward contracts can be customised to a particular product, quantity, and delivery date. Forward contracts are considered over-the-counter (OTC) instruments because they are not traded on a centralised exchange. Forward contracts, for example, can enable agricultural producers and users to hedge against price changes in the underlying asset or commodity. When opposed to contracts that are marked to market on a regular basis, financial institutions that begin forward contracts have a higher level of settlement and default risk.
A forward contract, unlike a typical futures contract, can be tailored to a specific commodity, quantity, and delivery date. Grain, precious metals, natural gas, oil, and even poultry are all examples of commodities that can be exchanged. Settlement of a forward contract might be made in cash or by delivery. While the lack of a centralised clearing house makes it easier to personalise terms, it also raises the danger of default.
A forward contract is a sort of derivative. A derivative is a financial contract between two or more parties in which the value of the contract is linked to the value of an underlying asset or collection of assets. For example, commodities, foreign currencies, market indexes, and individual stocks, can all be used as underlying assets for derivatives.
Basic terms used in forward contracts
Here are a few terms, that a trader should be knowing before trading in forwards:
- Underlying asset: The underlying asset refers to the one indicated in the contract. This underlying asset could be a commodity, a currency, a stock, or something else entirely.
- Quantity: This mostly refers to the contract’s size, expressed in units of the asset being purchased and sold.
- Price: It is also necessary to provide the price that will be paid on the expiration date.
- Expiration date: This is the date on which the contract is finalised and the asset is delivered and paid for.
Types of forward contracts
Forward contracts are generally used by traders to protect themselves from currency and commodity market volatility. Forward contracts might incorporate a variety of assets, including equities, treasury, real estate, etc. Forward contracts can be used as a hedging tool. Investors, on the other hand, use it for speculation in order to profit from the movement of security prices. Because currencies make up the majority of forward contracts, the majority of forward contracts are currency-specific. Following are the types of forward contracts:
Window Forwards
Investors can acquire currencies using forward contracts with a variety of settlement dates. Essentially, such contracts allow investors to obtain a more favourable and convenient exchange rate than they would receive through a traditional forward contract.
Mr. X, for example, has three months to reach an agreement with his US-based supplier. The date, on the other hand, is not fixed. As a result, Mr. X chooses a window forward contract, which allows him to trade on any day between the 1st and the 30th of the next 4th month, but not later than the 30th.
Long-Dated Forwards
As the name implies, these contracts have a substantially longer settlement time than standard forward contracts. A normal forward contract usually has a 12-month expiration period. Long-dated forwards, on the other hand, can have a maturity date of up to ten years. Except for a later settlement date, long-dated futures have the same characteristics as normal forward contracts.
Non-Deliverable Forwards (NDFs)
Non-deliverable forwards are a distinct sort of forward contract from ordinary forward contracts. Physical delivery of the security/asset of monies is not required in such transactions. Rather, the parties simply trade the differential amount at the moment of settlement. The difference between the contract rate and the market rate at the time of settlement is calculated. These sorts of forward contracts are typically used by investors who do not have enough funds, do not want to commit funds, or do not want to block large amounts of money.
Assume that XYZ Inc. will receive 1 million BRL for a sale made this month (April) after three months. It goes to a Brazilian bank in order to enter into a forward contract of selling 1 million BRL after 3 months at a rate of 4 BRL for $1.
Now, there are 2 possibilities:
- Case 1: After 3 months, $1 = 3.7 BRL, or
- Case 2: After 3 months, $1 = 4.25 BRL.
XYZ Inc. would receive $250,000 for sure because of entering into an NDF contract.
In case 1, amount to be received by XYZ Inc. = $270,270 (1 million BRL / 3.7). Here, the spot price turns favourable for XYZ Inc. Now the Brazilian bank will pay the difference of spot rate and forward rate to XYZ Inc. which is $20,270 (i.e., 270,270 – 250,000).
In case 2, amount to be received = $235,294 (1 million BRL / 4.25) which is less than $250,000. Here, spot price is unfavourable for XYZ Inc. Now the difference paid by the bank is $14,706 (i.e., 250,000 – 235,294).
Flexible Forward
Investors can exchange funds more easily using this sort of forward contract. Alternatively, investors who use such a contract have the option to exchange funds before the settlement date. Parties can use this contract to either exchange funds immediately or make many payments prior to the settlement date.
Assume Mr. X imports $500,000 worth of goods from a US-based exporter to India. He gets into a flexible forward contract since he is aware of exchange rate fluctuations. This will allow him to make payments at different times over the contract’s duration, depending on when the exchange rates are favourable to him.
Closed Outright Forward
This is the most straightforward sort of forward contract. These forward contracts are also known as European contracts or Standard Forward Contracts. Investors can use these contracts to trade the underlying asset at a certain future date.
Assume you have established a business relationship with a foreign exporter. The payment deadline is the 24th of the following month. By entering into a closed outright forward contract for the 24th of the next month, you can lock in the exchange rate.
Fixed Date Forward Contracts
The underlying asset is only exchanged at a predetermined maturity date in this sort of forward contract. Alternatively, we may state that such contracts have a set maturity date. The majority of forward contracts are exclusively for defined dates.
Option Forward Contract
Flexible forward contracts are similar to these forms of forward contracts. A forward option contract allows participants to trade the underlying security at any time during a specified period.
Important clauses of a forward contract
Forward contracts are agreements in which the buyer or seller agrees to buy or sell a certain instrument or entitlement at a specific price at a future date. A company may employ forward contracts for hedging purposes, such as to safeguard against future foreign currency exchange rate uncertainties. Forward contracts can also be used to try to protect the value of the company’s current securities holdings in currencies other than the portfolio’s base currency.
General clauses
The general clauses that a forward contract has are discussed hereunder.
Title of agreement
The nature of the contract is reflected in the agreement’s title. There are no legal requirements as to how the agreement’s title should be written. However, once we read a title, we should be able to comprehend what the agreement is about rather quickly. The title is usually written in capital characters, in the middle, and underlined.
Date of execution and effective date
An agreement has an execution date that is the date on which the terms and conditions were agreed upon and signed, and an effective date that is the date on which the contract begins and the terms and conditions become legally binding.
Name of the parties
All contracting parties’ names and addresses should be clearly stated, with no spelling errors. This section or clause should include contact information such as the person’s or company’s name, address, fax number, phone number, and email address, as well as the company’s identification number and registered office, if applicable.
Recitals
Recital clauses provide background information on the party. This clause usually contains information about the parties’ occupations, businesses, brokers, exchange registration, broker registration number, and so on. Recitals may also contain information about the parties’ motivations for entering this contract. The term “WHEREAS” (which means “considering that” or “that being the case”) is usually used to start a recital clause. Recitals in a contract play an important function since they describe the nature of the parties’ contractual relationships as well as the contribution made by each party.
Definitions
Every agreement has its own set of words that have a distinct meaning associated with it. To distinguish it from other words, the initial letter of the word specified in the defining clause should be capitalised. Such words can be given either separately in defining clauses, as in the example above, or in double inverted commas and brackets.
Obligation
A forward contract is a customised derivative contract that binds counterparties to buy (receive) or sell (deliver) an asset at a predetermined price at a specified date in the future. A forward contract can be used for hedging or speculation, but because of its non-standardized character, it’s best for hedging. Every obligation must be specified clearly by both parties.
Confidentiality
All exchange of information between the parties to the agreement must be deemed to be confidential.
Term of contract
The term represents the duration of the contract period.
Termination
Even if the contract’s duration or term is set in stone, the contract can be terminated early by mutual permission of the parties or by the occurrence of a specific event, such as a change of ownership, death, disability, or insolvency of either party, or due to force majeure. Prior to termination, however, adequate written notice should be given.
Terms of settlement
The end of the contract is the settlement date for forwards. Many hedgers utilise forward contracts to reduce an asset’s price volatility. A forward contract is not vulnerable to price fluctuations because the terms are set when it is executed. In a forward contract, there are two options for settlement, namely, delivery or cash basis. If the contract calls for the seller to deliver the underlying item or assets to the buyer, the seller must do so. The buyer then pays the agreed-upon payment in cash to the vendor.
Representations and warranties
A representation is a statement that the facts stated in this contract are accurate, used to persuade another party to enter into a contract or take some other action. The term “representation” can refer to either a person or a company. Warranties, on the other hand, offer not only to provide assurance regarding the party/company or product, but also to indemnify in the event that the warranties provided fail to satisfy the criteria.
Consideration
Consideration means something in return. No contract is valid without consideration. Forward contracts can be tailored to a specific commodity, amount, and delivery date.
Indemnification
To indemnify means to compensate for a loss. Indemnity is a promise made by one party to another that the other party will be held harmless as a result of another party’s actions.
Force majeure
As we all know, some natural events are beyond our control. Floods, earthquakes, pandemics and other uncontrollable events are examples of uncontrollable events. Including a language like this in a contract allows the parties to operate without any ambiguity or confusion.
Governing laws
Governing laws are important in all types of contracts, but they are especially important in international contracts. Multiple sets of laws will apply if controlling laws are not adequately established, causing confusion and laying the groundwork for future disputes.
Jurisdiction
The term “jurisdiction” refers to the legal authority over a specific geographical area. The contracting parties may not live in the same city or country. As a result, it is critical to include this clause in the contract to determine where any litigation should be brought in the event of a dispute. It is preferable to employ exclusive jurisdiction to avoid difficulties. If the contract does not specify jurisdiction, the standards of jurisdiction set down in the Civil Procedure Code of 1908 will apply.
Signature
The contract must be signed by both parties in order for it to be legally binding. It might be either an electronic or a manual signature.
Parent clauses
The parent clauses of a forward contract are provided hereunder:
Miscellaneous
The company and the trustee both agree that when money is transferred from the trust account, the trustee will adhere to the security standards as provided in the agreement. The company and the trustee will only give authorised people access to confidential information about security processes. If any party has cause to believe that unauthorised persons have gained access to such secret information, or if its authorised personnel have changed, the other party must inform remaining parties immediately.
Purchase and sale terms and procedures
If any suit, action, procedure (including any governmental or regulatory investigation), claim, or demand is launched or claimed against any person in connection with which indemnity may be sought, such person (the “Indemnified Person”) must promptly notify the person against whom indemnification may be sought (the “Indemnifying Person”) in writing. Provided, however, that failure to notify the Indemnifying Person does not relieve it of liability to the extent that it has been materially prejudiced (through the forfeiture of substantive rights or defences) as a result of such failure. If any such proceeding is brought or asserted against an Indemnified Person, the Indemnifying Person shall retain counsel reasonably satisfactory to the Indemnified Person to represent the Indemnified Person in such proceeding (who shall not, without the Indemnified Person’s consent, be counsel to the Indemnifying Person) and shall pay the fees and expenses of such counsel related to such proceeding, as incurred.
Parties
The underwriters and the company, as well as their respective successors, will benefit from and be bound by this agreement. Nothing in this agreement is intended or shall be construed to give any person, firm, or corporation any legal or equitable right, remedy, or claim under or in respect of this Agreement or any provision herein contained, other than the Underwriters and the Company and their respective successors, and the controlling persons and officers and directors and their heirs and legal representatives.
Services provided
The service that the seller wants to provide to the buyer is clearly aid down under this head.
Criteria for acceptability
The seller shall sell and deliver product to the buyer that fully conforms to the buyer’s quality specifications as will be provided in the appendix of the agreement entered between the two.
How does a forward contract work
The simplest way to understand how forward contracts work is by using an example. Consider the case of an orange grove owner who has 500,000 bushels of oranges ready to be sold in three months. However, there is no way of knowing how the price of oranges in the commodities market would fluctuate between now and then. The orange grower can lock in a specific price per bushel, when it’s time to sell the harvest by entering into a forward contract with a buyer. The buyer and seller’s outcomes are determined by the spot price of oranges. If the per bushel price at the moment of sale is the same as the contract price, the contract is said to be fulfilled.
If the contract expires with the spot price higher than the forward price, the seller must pay the buyer the difference between the forward and spot prices. If the spot price falls below the forward price, the buyer will be responsible for the difference. When the contract expires, it must be settled in accordance with the terms. Each forward contract might have its own set of terms. These derivatives aren’t traded on a stock market like stocks are. They are, instead, over-the-counter investments. This implies they are mostly employed by institutional investors like hedge funds and investment banks, and they are not as accessible to regular retail investors.
In a forward contract, there are two options for settlement, namely, delivery or cash basis. If the contract calls for the seller to deliver the underlying item or assets to the buyer, the seller must do so. The buyer then pays the agreed-upon payment in cash to the vendor. When a contract is concluded on a cash basis, the buyer still pays on the due date, but no assets are exchanged. The difference between the current spot price and the future price determines the amount of payment. This presupposes that the two prices diverge at the time of settlement. If there is no difference and they are the same, the contract is resolved without the need for a cash exchange.
Why use forward contracts
The ability to lock in pricing for a specific asset is a benefit for the seller in a forward contract. This allows you to manage risk by assuring that you can sell the asset at a price that you specify. Forward contracts can also be used by buyers to lock in pricing. A forward contract, for example, could allow you to buy the orange supply you need to keep creating juice at a fixed price if you operate an orange juice firm. This can help with expense management and revenue forecasting.
Let’s imagine you want to sell 100 tonnes of grain to a large store in the United States in 60 days for $150 per tonne. After the 60-day period has elapsed, you must provide 100 tonnes of maize, for which the store must pay $15,000 (100 tonnes x $150). Regardless of whether the price of corn is trading at $150 or not, you would be required to sell at the agreed-upon amount. This means that when you take delivery, you may find yourself selling at a higher or a cheaper price than the market price. If neither you nor the buyer want to swap the corn before the expiration date, you might settle in cash. There are no actual goods given in this case. The difference between the negotiated price and the current price will be the settlement amount; the buyer will pay the seller if the asset price falls, and the seller will pay the buyer if the asset price rises.
Pros of a forward contract
- Forward contracts are simple to comprehend, making them an excellent tool for novices.
- Forwards are commonly used for speculation or hedging since the contract price remains constant regardless of whether the asset price changes, traders can be certain of the price they will be purchasing or selling at.
- Forward contracts, as previously stated, provide a great deal of flexibility because dates and amounts can be customised. Even though forward contracts have an agreed-upon expiration date, this does not imply that they must be maintained open indefinitely. If you wish to reduce your losses or capture winnings, most forward contracts can be closed early.
Cons of a forward contract
It’s critical to understand the risks that both parties face when they enter into a forward contract.
- First, there is no guarantee of product quality because forwards are exchanged over-the-counter rather than on an exchange, and asset variation is not regulated. The exchange, on the other hand, would be unaffected if traders chose to settle in cash rather than taking delivery of the asset.
- Second, there is the possibility of default. A forward contract’s value improves for one party while becoming a liability for the other when the price fluctuates. This implies that there is a degree of counterparty risk, in which the contract may not be honoured despite the fact that it is obligated.
Risks of forward contracts
- As many of the world’s largest firms utilise forward contracts to hedge currency and interest rate risks, the market for forward contracts is enormous. The extent of this market is difficult to assess because the terms of forward contracts are only known by the buyer and seller and are not available to the general public.
- In the worst-case scenario, the forward contracts market’s huge size and unregulated structure make it vulnerable to a cascade series of defaults. While banks and financial firms can reduce this risk by carefully selecting counterparties, large-scale default is still a possibility.
- Another risk associated with forward contracts’ non-standard nature is that they are not marked-to-market like futures and are only resolved on the settlement day.
- What if the contract’s specified forward rate differs significantly from the spot rate at the time of settlement? In this instance, the financial institution that originated the forward contract has a higher level of risk in the event of the client’s default or non-settlement than if the contract was marked to market on a regular basis.
After a general idea about the possible risks that attracts a forward contract, it is now necessary for us to know the three frequent types of risks that majorly surround a forward contract:
Regulatory risks
There is no regulatory authority that governs the agreement concerning a forward contract. It is carried out with the agreement of both parties involved in the contract. As there is no regulating authority, the danger of either party defaulting grows.
Liquidity risks
The lack of liquidity in the forward contract may influence whether or not to trade. Even if a trader has a solid trading opinion, liquidity may prevent him from executing the plan.
Default risks
In the event that the client defaults or does not settle, the financial institution that created the forward contract is exposed to a high amount of risk. The basic objective of forward contracts is to help buyers and sellers manage the volatility that comes with commodities and other financial transactions. Because they are over-the-counter investments, they are riskier for both parties. Forward contracts can be used by traders who seek to diversify their portfolios beyond stocks and bonds.
How is a forward rate calculated?
The answer to the question provided above is straightforward. The rates at which a certain currency that you want in the near future is determined are governed by market factors, namely demand and supply. The demand and supply factors influence exchange rates in a free-floating exchange rate system. Interest rates, inflation, GDP growth rate, monetary and fiscal policies, the balance of payment position, and other macroeconomic factors all influence supply and demand. Inflation and interest rates are two of the most crucial factors among these numerous. The relation between the above three is christened in the market parlance as follows:
- Exchange Rate and Interest Rate – Interest Rate Parity (IRP)
- Exchange Rate and Inflation – Purchasing Power Parity (PPP)
- Interest Rate and Inflation – International Fisher Effect (IFE)
Interest Rate Parity (IRP)
To elucidate the impact of interest rate changes on foreign exchange when all other variables remain constant. As a result, if one country’s interest rate is lower than the other, the currency of the first country will be at a forward premium. In fact, IRP goes a step further and uses a formula to quantify the premium.
Purchasing Power Parity (PPP)
The relationship between exchange rates and inflation is expressed using parity theory, which assumes that all other variables remain constant. Money loses its purchase value as a result of inflation. As a result, if one country’s inflation is larger than another’s, its currency should devalue.
International Fisher Effect (IFE)
This is a parity relationship derived from IRP and PPP between interest rates and inflation. According to IFE, the actual interest effect should be the same in all nations.
The Interest Rate Parity theory is believed to be better than the other theories since it considers the economy’s running interest rate. In many circumstances, the forward rate is greatly influenced by the interest rate and the investor’s predicted income or loss reduction objective.
Possible mistakes that can be avoided while drafting a forward contract
A list of general mistakes that are encountered while drafting a forward contract, and which must be avoided are provided hereunder:
Appropriate template must be followed:
Googling and utilising the first template one comes across contributes towards being the gravest mistake while drafting a forward contract. Unless you have been forced to use a specific template (by your boss/firm/etc), the best strategy is to browse at least four to five templates, analyse their qualities, and then combine them into one that will be most useful to you.
Checklist of clauses for a contract:
Create a list of what should be included in your contract based on the Client’s requirements. You will not miss any of the contract’s required clauses if you do it this way.
Recitals:
Recitals are the first few paragraphs of any agreement. The recitals clearly identify the parties engaged in the transaction and establish the tone for the contract at the outset.
Clear definition of terms used in contract must be provided:
Ambiguity in term definitions is a thorny issue that no client likes to be on the receiving end of. Ambiguous phrases expose a party to litigation, liabilities, breach, and a great deal of chaos. It is necessary to have a clear and exact definition of terminology.
Conditions which qualify as breach & termination clause:
A drafter should always evaluate what constitutes a breach of the provisions of the current agreement they are constructing. This will be given in accordance with the client’s wishes. Non-payment of timely fees, non-delivery of services within the given time, the disclosure of confidential information, or the establishment of a competitor firm are all examples of circumstances in which the client may seek to terminate the agreement.
Meticulous mechanism for payments and consideration:
One of the most important things to remember while drafting is to give a complete system for the party to carry out its payments and consideration to the other parties. There is no contract if there is no proper consideration in exchange for a service delivered. Set the dates, intervals, amount, and medium, as well as the compensation method in the event of late payments. This will ensure the existence of a contract as well as prevent further payment disputes.
Dispute resolution mechanism:
Every good contract calls for a specific format for resolving disagreements. No one enters into a contract with the goal of producing complications or causing a disagreement. They are in it to get mutual benefits. A well-drafted contract should have an internal dispute resolution system, with a provision allowing the parties to go to an arbitration panel only if that procedure fails. This is preferable since litigation might be prohibitively expensive for the parties in the long term.
Schedules:
Schedules are finalised at the conclusion of a contract. You should always be cautious when drafting contract schedules. Most of the time, the timetables include all of the critical elements that make or break a deal. This is where the figures and project details are kept. One of the most serious flaws in a contract is failing to cover all of your clients’ criteria and in the form in which they want them to be addressed.
Buying forward : an insight
- When an investor negotiates the purchase of a commodity at a price agreed upon today but receives delivery at a later date, this is known as buying forward. When investors and traders anticipate the price of a commodity will rise in the future, they purchase forward. Buying ahead is a notion that is frequently applied to currencies and commodities, but it may also be applied to nearly any security via a forward contract. Purchasing a commodity at a price agreed upon today for delivery or consumption at a later date is known as buying forward.
- Buying forward is most frequently associated with currencies and commodities, but a forward contract can be used to buy practically any security. Buying forward allows the investor to lock up the commodity or security at a lower price now and then sell when prices rise.
- When an investor anticipates a rise in pricing or an increase in demand levels for a certain good or investment, they may choose to buy forward. Buying ahead allows an investor to lock in a lower price for a commodity or security now and then sell when prices rise. The contract to acquire the goods or security might be sold to another party who will take real delivery, depending on how buying forward is done.
- Buying forward used to entail purchasing a good when supplies were plentiful, accumulating it, and then selling when supplies ran out. Some commodities, but not all, could be handled in this manner.
- Over time, the market changed, and the forward contract mostly supplanted physical stockpiling. A forward contract is a tailored agreement between two parties that specifies the asset to be purchased at a later period as well as the price to be paid.
- As they influence production, forward contracts can have a significant impact on the market for a certain good. The natural breeding seasons, for example, cause seasonal glutes and falls in meat and cattle production. Producers might adjust their breeding cycles to come in line if they observe a lot of buying forward through contracts.
- In order to promote off-season production, this form of buying forward normally necessitates paying a premium at first, but the obvious market signal will eventually benefit both buyers and suppliers.
Forward Contracts vs. Futures Contracts
- Future contracts are a sort of derivative similar to forward contracts, although they are not the same. They also enable two parties to agree to acquire or sell an asset at a future date for a defined price. They are distinguished from forward contracts by three fundamental characteristics.
- Futures contracts are traded on an exchange.
- Rather than settling at the end of the contract, settlement occurs on a daily basis.
- Futures contracts are not modifiable, but they are standardised.
- Another significant distinction is risk and how it is managed by a clearing house. In an investment transaction, a clearing house acts as a go-between for the buyer and seller. It is in charge of ensuring that the contract is properly resolved.
- Forward contracts do not go through a clearing house like future contracts do. This suggests that both parties to the forward contract are willing to take on more credit risk. The danger is that one party or the other will break the agreement’s terms. Building a premium into the forward contract to cover the chance of default is one method to mitigate this risk.
Forward contracts in India
A forward contract, as defined by the Forward Contracts (Regulation) Act, 1952, which governs commodities trading in India, is a contract for the actual delivery of goods, as opposed to a futures contract, which allows the buyer to pay the deal in cash. In the commodity market, forward contracts were introduced in 2014, but they are not permitted in the stock market. The majority of commodity forward contracts take place outside of trading platforms around the world. On major commodity exchanges like the Chicago Mercantile Exchange (CME Group) and the London Metal Exchange (LME), only futures and options are traded.
Master Circular on Risk Management and Inter-Bank Dealings issued by the Reserve Bank of India (RBI) on 1st July, 2009 stated that a person residing in India may enter into a forward contract with an Authorised Dealer Category-I bank (AD Category I bank) in India to hedge an exposure to exchange risk in connection with a transaction for which the Foreign Exchange Management Act, 1999, or rules, regulations, directions, or orders made or issued thereunder, permits the sale and/or purchase of foreign exchange.
Forward trading in various commodities is currently available through the National Commodity and Derivatives Exchange Ltd (NCDEX) and the National Multi-Commodity Exchange of India Ltd (NMCE). NCDEX features a basket of over 25 commodities for forward transactions, whereas NMCE recently debuted forward contracts in rubber. At the moment, the Multi-Commodity Exchange of India Ltd (MCX) does not provide forward contracts.
SEBI’s take on forward contracts in India
- Sources directly involved in the conversations between Securities and Exchange Board of India (SEBI) and exchange officials claimed that the SEBI, which took over regulation of commodities markets as well, is not comfortable with forward contracts in commodity exchanges. SEBI’s concern, they claim, derives from two factors, one, unlike futures contracts, forward contracts are not standardised and forward contracts have higher counterparty risk.
- SEBI’s main headache is that, despite being traded on an exchange platform, a forward contract is not a standardised contract with complete counterparty risk protection. In the securities market, such an instrument is not permitted, and SEBI does not wish to begin regulating commodities with such grey areas.
- R.S. Loona, managing partner of Alliance Corporate Lawyers, a corporate law firm, said there have been concerns in the commodities market with forward contracts in the past, which SEBI may be concerned about. In the derivatives segment, SEBI now allows only futures and options.
- SEBI will be able to monitor forward trading rather easily (in comparison to FMC) because of its resources. SEBI should look at forward trading with a better regulatory framework and complete counterparty risk assurance, which is given for any exchange-traded product, rather than starting to regulate commodities with any grey areas.
Key takeaways about forward contracts
- A forward contract is a contract that allows you to buy or sell an underlying asset at a specific price on a future date.
- Delivery or cash basis are the two options for settlement.
- Forward and future contracts have distinct characteristics.
- Trading these contracts has some risks.
- Forward contracts are primarily used to assist buyers and sellers in managing the volatility associated with commodities and other financial transactions.
For instance, suppose you are a farmer who wants to sell wheat at the present rate of Rs. 18, but you are aware that wheat prices are expected to plummet in the coming months. In this scenario, you sign a contract with a grocery store to sell them a specific amount of wheat for Rs. 18 over the course of three months. This is a classic example of a forward contract.
Conclusion
Both buyers and sellers use forward contracts to manage the volatility associated with commodities and other alternative investments. Because they are over-the-counter investments, they are usually risky for both parties. They are not to be confused with futures contracts, despite their similarities. These are more accessible to regular investors who want to diversify their portfolios beyond stocks and bonds.
References
- https://smartasset.com/investing/forward-contract.
- https://efinancemanagement.com/derivatives/types-of-forward-contracts
- https://www.ig.com/en/glossary-trading-terms/forward-contract-definition.
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