Forward Contract

A forward contract is a type of derivative contract where two parties agree to buy or sell an
asset at a future date (maturity or expiration date) for a price agreed upon today (the forward
price). The asset could be commodities, currencies, stocks, bonds, or any other tradable
instrument. Forward contracts are highly customizable. Parties can negotiate and agree on the
terms, including the specific details of the asset, quantity, price, and delivery date. The
settlement of a forward contract can occur through physical delivery of the underlying asset
or cash settlement, depending on the terms agreed upon by the parties. Forward contracts are
not standardized and are often unique to the parties involved. As a result, there is no
secondary market for these contracts, making them less liquid compared to exchange-traded
derivatives. Forward contracts play a crucial role in risk management, allowing businesses to
lock in prices for future transactions and thereby manage price volatility.

Key Components:

• Forward Price: The price at which the asset will be bought or sold in the future.

• Maturity Date: The date on which the transaction will be settled, and the asset is
delivered.

Purpose:

• Hedging: Businesses and investors often use forward contracts to hedge against the
risk of adverse price movements in the underlying asset.

• Speculation: Traders may enter into forward contracts to speculate on future price
movements, hoping to profit from favorable price changes.

Limitations of Forward Markets: -

The forward market, which includes forward contracts, has certain limitations and challenges
that market participants need to be aware of. Here are some key limitations of the forward
market:

1. Customization and Lack of Standardization:

Forward contracts are highly customizable, with terms negotiated between parties.
While this customization provides flexibility, it can also lead to a lack of
standardization. This makes it challenging to find a ready market and increases the
difficulty of pricing and comparing different forward contracts.

2. Counterparty Risk:
 One significant risk in forward contracts is counterparty risk, where one of the parties
may default on their obligation. There is no clearinghouse or exchange acting as an
intermediary to guarantee the performance of the contract.

3. Illiquidity:
The forward market is often less liquid than other financial markets, such as futures
markets. Finding a willing counterparty for a specific forward contract can be
challenging, especially for less common assets.

4. No Marking-to-Market:
Unlike futures contracts, which involve daily marking-to-market, forward contracts
do not. The absence of this mechanism means that gains or losses are not settled
regularly, and participants must wait until the maturity date for settlement. This delay
introduces credit risk.

5. Inflexibility:
Once a forward contract is established, changing its terms can be challenging. This
lack of flexibility can pose issues when market conditions or the parties'
circumstances change.

6. No Secondary Market:
Forward contracts are not traded on organized exchanges, and their customized nature
makes it difficult to create a secondary market. Participants may find it challenging to
exit or transfer their positions before the contract's maturity date.

Despite these limitations, the forward market remains a valuable tool for certain participants,
especially those seeking tailored and flexible arrangements for managing specific risks.