First, let us understand the concept of 'Forwards.'
What is a forward contract?
A forward contract is an agreement to buy or sell a particular asset at a pre-decided price in future.
Remember the contract between the farmer and the ITC to buy and sell a specified quantity of wheat at a specific date and at a specific price is known as a forward contract.
In this case, one of the parties entering into a forward contract assumes a long position to buy the underlying asset at a certain specified price and the other party assumes a short position to sell the asset on the same date for the same price. A forward contract is a type of customized contract, can be between any two or more parties, and is not traded on stock exchanges and thus there is no middleman in the contract. Owing to this nature of the contract, there is a high probability of default by any of the parties, which is known as the "Counterparty risk".
Features of a forward contract
- Each contract is custom designed and hence is unique in terms of contract size, expiration date and the asset type and quality.
- This is a bilateral contract and hence exposed to counterparty risk.
- On expiration date, the contract has to be settled by delivery of the asset.
- The contract price is not available in the public domain.