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

Global equity indexes, Global Equity Indexes: As described earlier in t...

Global Equity Indexes: As described earlier in this chapter, there are several stock market indexes available which depict the performance of particular sectors and a country a

Important features floating rate notes, Reference Index Every FRN choos...

Reference Index Every FRN chooses its own reference index upon which the calculation of each successive new coupon is based. The most commonly used reference index is LIBOR. It

Explain hard capital rationing and soft capital rationing, Explain Hard cap...

Explain Hard capital rationing and Soft capital rationing The NPV decision rule to admit all projects with a positive net present value requires the existence of a perfect cap

Gathering competitive intelligence information, K is a kitchen and bathroom...

K is a kitchen and bathroom design and installation company which currently has showrooms in one region only of Country T. The company has enjoyed considerable success since it was

Capital asset pricing model, Cascade Water Company (CWC) currently has 30 0...

Cascade Water Company (CWC) currently has 30 000 shares of common stock outstanding, trading at a price of R42 per share. CWC also has 500 000 bonds outstanding that are currently

Cash discount, Which one is true 1.the higher the discount rate the lower ...

Which one is true 1.the higher the discount rate the lower the cost of trade credit 2.the higher the discount rate the higher the cost of trade credit 3.cost of trade credit duri

What are the ifrs 8 operating segments, What are the IFRS 8 operating segme...

What are the IFRS 8 operating segments IASB issued IFRS 8 operating segments in November 2006 (which replaced IAS 14). This continues IASB's work in its joint short-term conver

Computation of overall cost of capital, Q. Computation of overall Cost of C...

Q. Computation of overall Cost of Capital? Computation of Value of the Firm (V) & Overall Cost of Capital when debt is lowered to Rs, 1, 00,000 When the debt is lowered to R

Determine the objectives of the firm, Determine the Objectives of the Firm ...

Determine the Objectives of the Firm Objectives of the Firm - Profit Maximisation and Wealth Maximisation To put it simply, we may say that goal of any business is to max

Operating cycle, Explain the operating cycle of a vegetable growing busines...

Explain the operating cycle of a vegetable growing business

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