Forwards

What is a Forward Contract?

A forward contract is a type of derivative that obligates two parties to trade an asset at a predetermined price on a predetermined date in the future. Forward contracts are typically used to hedge against risk or to speculate on the future price of an asset.

How do Forward Contracts Work?

Let’s say that you are a farmer who is expecting to harvest wheat in 6 months. You are concerned about the possibility of the price of wheat falling before you harvest your crop. You can enter into a forward contract to sell your wheat at a predetermined price in 6 months. This will protect you from the risk of the price of wheat falling below the predetermined price.

On the other hand, let’s say that you are a grain trader who believes that the price of wheat is going to rise in 6 months. You can enter into a forward contract to buy wheat at a predetermined price in 6 months. This will allow you to lock in the price of wheat and profit if the price of wheat rises above the predetermined price.

MCQs on Forward Contracts:

1. Which of the following is not a characteristic of a forward contract?
   • It is a legally binding contract.
   • It is traded over-the-counter.
   • It is settled on a future date.
   • It is used to hedge against risk.
   • All of the above are characteristics of a forward contract
   • Answer: It is traded over-the-counter.
2. Forward contracts are typically used to hedge against risk or to speculate on the future price of an asset.
   • True
   • False
   • Answer: True
3. Forward contracts are typically used by large institutions and sophisticated investors.
   • True
   • False
   • Answer: False
4. Forward contracts are typically more liquid than futures contracts.
   • True
   • False
   • Answer: False
5. Forward contracts are typically more expensive than futures contracts.
   • True
   • False
   • Answer: False

Conclusion

Forward contracts are a versatile tool that can be used to manage risk and generate income. However, they are also complex instruments and should only be used by experienced investors.

Here are some additional points to keep in mind about forward contracts:

• Forward contracts are legally binding contracts. This means that both parties are obligated to fulfill their obligations under the contract, even if the price of the underlying asset moves in an unexpected direction.
• Forward contracts are typically traded over-the-counter. This means that they are not traded on an exchange. This can make them more difficult to trade and less liquid than futures contracts.
• Forward contracts are settled on a future date. This means that both parties must deliver the underlying asset on the settlement date. This can be a logistical challenge, especially for commodities that are difficult to transport.

It is important to understand the risks and limitations of forward contracts before using them.