Meaning and definition of forward contract
Forward contract can be defined as a cash market transaction which involves the delivery of the commodity being deferred until after the contract has been created. Even though the delivery is made in future, the price is decided on the initial trade date. As explained by Investopedia, a large number of forward contracts don’t possess standards and are also not traded on exchanges. To illustrate, a farmer, for example, would use a forward contract to “lock-in” a price for the grains for the forthcoming fall harvest.
In finance, a forward contract is delineated as a non-standardized contract between two parties for sale or purchase of an asset at a specified future time at a price agreed at present date. In a forward contract, the party agreeing to purchase the underlying asset in the future assumes a long position, and the party agreeing to sell out the asset in future assumes a short position. The price which is settles on is referred as the delivery price, which is equivalent to the forward price at the time of entering into the contract.
Reason for a Forward Contract
There is no strategic reason for the subsistence of a forward contract, i.e. forward contract can be used even in a world without uncertainty. This is because of the existence of Stackelberg incentives to anticipate their production through the way of forward contracts.
How does a Forward Contract work?
The working of a Forward Contract can be illustrated as follows. Let us presume that Bob wants to purchase a house after a year from now. At the same time, let us presume that Andy owns, at present, a house worth $100,000 which he wishes to sell after a year from the present date. Both these parties could enter into a forward contract with one another. Assuming that they both agree on the sale price of $104,000 in a year’s time, Andy and Bob have entered into a forward contract.
After the completion of one year, if the current market value of Andy’s house is $110,000, but just because Andy is indebted to sell to Bob for $104,000, Bob will make a profit of $6,000.