Forward contracts, Financial Management

Assignment Help:

Forward Contracts:

The origin of forward contracts is lost in history. Some authors suggest that, it was India where these contracts took birth, while some others suggest that Roman emperors employed forward contracts to procure foodgrains from Egypt. Irrespective of this fact, they are serving important social objectives in the present age. It is estimated that forward contracts worth $500 billion are being entered into every year.

Before the industrial revolution, it was not an easy task to export commodities from one country to another. The probability that the price could change drastically during the period the commodities were being transported, was high. Under these conditions, the traders required a mechanism where they could protect their price and the profits. One of the viable methods to achieve this objective was to enter into a forward contract with the other trader. That is, the trader had to search for another trader who was willing to take position in the contract as a buyer. This created the first real problem. In the real world, it is quite difficult to find two traders with similar requirements.

In forwards, both the traders negotiate the details of the contract privately without the intervention of a third party. No doubt, this facilitates the traders to draw the details of the contract according to their needs, but this also increases the probability that one of the traders might default on fulfilling his obligation. This characteristic of the forwards contract changes the very nature of risk, as the fulfillment of the contract depends on the worth of the counterparty. This is the second real problem that one has to put-up with, if he wishes to deal in forwards.

In forward contracts, since the producers are not in direct contact with the purchasers, they have to route their contracts through middlemen. Middlemen play a crucial role in forward markets, as they purchase the produce from the producer by entering into a contract and then enter into a second contract with the other purchaser regarding the supply of the same. They bear the risk and have to perform the other part of the contract even when one of the parties default.

Therefore, they should not only be paid for their services, but also for credit risks they bear.

Although this may not be a problem on the face of it, the presence of an institution will bring much more stability to the whole process. This is a prerequisite for the retail investors to participate in forward markets. The other positive effect of this arrangement will be that the transaction costs will be lowered to a great extent. If we assume that a baker and a farmer (who enter into a mutual understanding on their trades) negotiate the same somewhere outside the exchange, without any of the exchange rules regulating them, then it would be a perfect example of a forward contract.

Although forward markets have been serving the society at large, they are not without their pitfalls as seen above. Now, we shall look at futures and how they were structured to overcome these problems.

 


Related Discussions:- Forward contracts

Share price, what course a decrease and increase in share price

what course a decrease and increase in share price

Benefits of mentoring for new members of staff, JB has recently joined the ...

JB has recently joined the Finance Department of P Company as a trainee management accountant. As part of the Company's induction, she has been offered a mentor. Though, since JB h

Nature of working capital, Nature of Working Capital: Working Capital ...

Nature of Working Capital: Working Capital Management is concerned with the problems that arise in attempting to organize the Current Assets, the inter-relationship and Curren

Mass and batch production, a) IPod -Line / Mass production is most suitable...

a) IPod -Line / Mass production is most suitable given that Apple can sell the standardised product to mass markets across the world. Only small variations to the production proces

Sally Thomson, Ask questionSally Thomson #Minimum 100 words accepted#

Ask questionSally Thomson #Minimum 100 words accepted#

Stable money measurement, Stable Money Measurement A business entity e...

Stable Money Measurement A business entity enters within numerous transactions in which affect the business in varied ways.  Therefore recording, classification and summarizat

Operating cycle, discuss the applicability of an operating cycle to poultry...

discuss the applicability of an operating cycle to poultry business in uganda.

Revenue bonds, A revenue bond is a special type of municipa...

A revenue bond is a special type of municipal bond distinguished by its guarantee of repayment from revenues generated by a specifie

Explain about money market mutual funds, Q. Explain about Money Market Mutu...

Q. Explain about Money Market Mutual Funds? Money Market Mutual Funds: Money market mutual funds (MMMFs) focus on short-term marketable securities such as TBs, CPs, CDs or call

What are the limitations of trade payable day''s ratio, What are the Limita...

What are the Limitations oftrade payable day's ratio? Year-end trade payables may not be representative of the year. Credit purchases are VAT exclusive in the income sta

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd