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

Calculate the net present value and payback period, Sarkozy Ltd is consider...

Sarkozy Ltd is considering the selection of one of a pair of mutually exclusive investment projects. Both would involve purchase of machinery with a life of five years. Projec

APC 308, the importance of a balanced capital structure and the problems wh...

the importance of a balanced capital structure and the problems which are associated with high levels of gearing

How working capital affect incremental cash flow estimation, How and why do...

How and why does working capital influence the incremental cash flow estimation for a planned large capital budgeting project?  Explain. Many large projects need additional worki

Briefly explain tagna, TAGNA (a) Market effectiveness is commonly discu...

TAGNA (a) Market effectiveness is commonly discussed in terms of pricing efficiency. A stock market is expressed as efficient when share prices fully and fairly reflect relevan

Beta value, Beta Value Risk is an important consideration while investi...

Beta Value Risk is an important consideration while investing in any security. It is the possibility that realised returns will be less than the returns expected. The degree, t

Explain benefits of currency option contract as hedging tool, What are the ...

What are the advantages or benefits of a currency options contract as a hedging tool compared with the forward contract? Answer:  The major advantage of by using options contra

Categorization of management risk , Categorization of management risk: ...

Categorization of management risk: Once each event has been evaluated, and been classified as to its probability and impact, the next step is to categorise those events. To do

Ledgers, Ledgers: Ledgers record all the entries into the Cash Books. T...

Ledgers: Ledgers record all the entries into the Cash Books. They use the concept of 'double entry' bookkeeping where every ledger entry must be accompanied by another ledger e

Determine what is current ratio - position ratios, Determine Current ratio...

Determine Current ratio  or working capital ratio CA = Current assets/Current liabilities (times) Current ratio measures the short term solvency or liquidity; it demonstra

What are the main criticisms of the payback method, How do we calculate the...

How do we calculate the payback period for a proposed capital budgeting project?  What are the main criticisms of the payback method? We calculate the reimbursement period for

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