Definition

A forward contract is a contract between two parties that commits them to buy or sell an asset at an agreed price on a
specific date in the future. This makes it a type of derivative, with the buyer taking a long position, and the seller a
short position. Commodities, currencies and financial instruments can all be traded in.

 Following are the risks involved while trading in the Forwards:

1. Regulatory Risks:
The Forwards contract there is no regulatory authority that governs the agreement.

It is executed by the mutual consent of both the parties involved in this contract.

As there is no regulatory authority, it increases the risk ability of either of the parties defaulting. 

2. Liquidity Risks:
As there is low liquidity in the forward contract, it may impact the decision of trading or not.

Even if a trader has a strong trading view, he may not be able to execute the strategy because of liquidity.

3. Default Risks:
The financial institution that drafted the forward contract is exposed to a high level of risk in the event of default or
non-settlement by the client.

Forward contracts mainly serve a purpose for buyers and sellers to manage the volatility that is associated with
commodities and other financial investments.

They are riskier for both parties involved as they are over-the-counter investments.

Traders who want to look beyond stocks and bonds for building a portfolio diversification can trade-in forward
contracts.

Application

Forward contracts are mainly used to hedge against potential losses. They enable the participants to lock in a price in
the future. This guaranteed price can be very important, especially in industries that commonly experience
significant volatility in prices. For example, in the oil industry, entering into a forward contract to sell a specific
number of barrels of oil can be used to protect against potential downward swings in oil prices. Forwards are also
commonly used to hedge against changes in currency exchange rates when making large international purchases.

Forward contracts can also be used purely for speculative purposes. This is less common than using futures since
forwards are created by two parties and not available for trading on centralized exchanges. If a speculator believes
that the future spot price of an asset will be higher than the forward price today, they may enter into a long forward
position. If the future spot price is greater than the agreed-upon contract price, they will profit.
Let us now look at what the payoff diagram of a forward contract is, based on the price of the underlying asset at
maturity:

Here, we can see what the payoff would be for both the long position and short position, where K is the agreed-
upon price of the underlying asset, specified in the contract. The higher the price of the underlying asset at maturity,
the greater the payoff for the long position.

A price below K at maturity, however, would mean a loss for the long position. If the price of the underlying asset
were to fall to 0, the long position payoff would be -K. The forward short position has the exact opposite payoff. If
the price at maturity were to drop to 0, the short position would have a payoff of K.