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Forwards contracts in derivatives

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Posted by : NIFM
11 November, 2013, 7:58 PM
In recent years, derivatives have become increasingly popular due to their applications for hedging, speculation and arbitraging. While futures and options are now actively traded on many Exchanges, forward contracts are popular on the OTC market. A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contract are: ·        They are bilateral contracts and hence exposed to counter party risk. ·        Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. ·        The contract price is generally not available in public domain. ·        On the expiration date, the contract has to be settled by delivery of the asset. ·        If the party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in high prices being charged. However, forward contracts in certain markets have become very standardized as in the case of foreign exchange, thereby reducing transaction costs and increasing transactions volume. Forward contracts are very useful in hedging and speculation.

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