Forwards are the simplest form of a derivative contract. We can define a forward contract as an agreement between two parties to exchange a specific asset on a specified future date at a predetermined price (forward price). Both the delivery and the payment is made on the specified future date.
The concept of forward contracts can be better understood with the following example.
A Ltd is a manufacturer of potato chips. It acquires a 1000 kgs of potatoes from the open market every month. Today is 1st of January and the prevailing market price of potatoes is Rs 10 per kg. It however anticipates, owing to a deficient monsoon, that the price of potatoes would escalate to Rs. 15 per kg in a month's time.
It therefore enters into a contract with a potato farmer to acquire from him 1000 Kgs of potatoes at a mutually determined price of Rs. 12 per kg; one month hence.
Therefore on the settlement date of the contract i.e on 1st of February, A ltd makes a payment of Rs. 12000 to the farmer and takes delivery of 1000 Kgs of potatoes from the farmer.
From the above example, the following features of a forward contract emerge.
1. A forward is a contract which is entered into today and settled at a future date.
2. The terms of the contract are mutually agreed upon by the parties to the contract. Forward contracts are therefore non-standardised.
3. The parties to the contract are bound to perform the contract on the contract settlement date.
4. There is a counter party risk involved.