Page 42 - DCOM510_FINANCIAL_DERIVATIVES

Unit 3: Introduction to Forward Contracts

promised), party A is exposed to counter-party risk i.e. risk of foregoing the deserving Notes
gain of ` 20 per kg. In case of future contracts, the stock/commodity exchange (through a
clearing house) gives a guarantee even if the counter party defaults. This is done through
a system of daily margins.
2. Each contract is custom designed, and hence, is unique in terms of contract size, expiration
date, the asset type, quality, etc.
3. In forward contract, one of the parties takes a long position by agreeing to buy the asset at
a certain specified future date. The other party assumes a short position by agreeing to sell
the same asset at the same date for the same specified price. A party with no obligation
offsetting the forward contract is said to have an open position.

Notes A party with a closed position is, sometimes, called a hedger.
4. The specified price in a forward contract is referred to as the delivery price. The forward
price for a particular forward contract at a particular time is the delivery price that would
apply if the contract were entered into at that time. It is important to differentiate between
the forward price and the delivery price. Both are equal at the time the contract is entered
into.

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Caution As time passes, the forward price is likely to change whereas the delivery price
remains the same.
5. In the forward contract, derivative assets can often be contracted from the combination of
underlying assets, such assets are generally known as synthetic assets in the forward market.
6. In the forward market, the contract has to be settled by delivery of the asset on expiration
date. In case the party wishes to reverse the contract, it has to compulsory go to the same
counter party, which may dominate and command the price it wants as being in a monopoly
situation.
7. In the forward contract, covered parity or cost-of-carry relations are relation between the
prices of forward and underlying assets. Such relations further assist in determining the
arbitrage-based forward asset prices.

8. Forward contracts are very popular in foreign exchange market as well as interest rate
bearing instruments. Most of the large and international banks quoted the forward rate
through their ‘forward desk’ lying within their foreign exchange trading room. Forward
foreign exchange quotes by these banks are displayed with the spot rates.
9. As per the Indian Forward Contract Act 1952, different kinds of forward contracts can be
done like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable
specify delivery (NTSD) contracts. Hedge contracts are freely transferable and do not
specific, any particular lot, consignment or variety for delivery. Transferable specific
delivery contracts are though freely transferable from one party to another, but are
concerned with a specific and predetermined consignment. Delivery is mandatory. Non-
transferable specific delivery contracts, as the name indicates, are not transferable at all,
and as such, they are highly specific.
In brief, a forward contract is an agreement between the counter parties to buy or sell a specified
quantity of an asset at a specified price, with delivery at a specified time (future) and place.

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