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What is a Forward Contract?

What is a Forward Contract? A Forward Contract is an exchange-traded transaction or an over-the-counter financial transaction that is set to deliver in the future for a commodity or a financial asset. With a forward contract, the buyer will be able to receive access to the financial asset which was initially agreed. After that, the seller will get a fixed price and a sales outlet coming from the buyer.

Upon the delivery of the financial asset, a call for payment will be required. This also includes the terms agreed by both parties and the provision for margin. Forward contracts can act as a very useful hedging tool that can be beneficial to both consumers and producers of commodities. But no matter how excellent it gets, just like trade forex, forward contracts can still fall into pitfalls sometimes. 

The Over-The-Counter Market and the Forward Contract

The transaction of forward contract mainly occurs between a seller and the buyer, under the basis of principal-to-principal. The two parties involved in the contract are obligated to do their side of the agreement through the contractual terms. Forward contract is quite popular, especially in the highly liquidated over-the-counter exchanges. This is mostly favored by both sellers and buyers because both parties are given the chance to negotiate the terms involved in the transaction.

Forward Contract Vs. Futures Contract

Forward contracts and futures contracts have clear differences, advantages and disadvantages. But one significant difference between these two is that the futures contract is standardized while the other, the forward contract is non-standardized. Here are the other known characteristics of futures contract:

     Cash settlements

     One stated commodity or financial asset

     Fixed amount of financial asset in every contract

     There is a quote in the currency of the asset

     End day of trading

     It has a minimum price fluctuation in every contract, called the tick value

     The corresponding delivery months

     The quality of the asset

Futures contract is subjected to both variation margin and the original margin. The marginal terms being followed in futures contracts states that the good-faith of both payment and deposit all undergoes negotiation. As for the forward contract, less liquidity is being offered since it can be offset to any other parties. Most of these forwards are offset based on the agreement of the two original parties.

Other Known Types of Forward Contracts

Synthetic Forwards

Some governments such as India and Russia strictly implemented a ban on trade forex. They did it to reduce the volatility of the exchange rate in their country. Amidst these countries, non-deliverable forwards are mainly developed.

Option-dated Forwards

You already know that a forward contract is an over-the-counter agreement that needs to be completed on the given due date. With this principle, late payments made by an overseas customer will encounter a problem. First, the forward contract needs to be settled then the bank can arrange a new contract that consists of the new date and the due of the cash flow. To avoid encountering this problem, an option date can be arranged.

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