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

Show the marketing issues, a) Cultural exports are the commercial transfer ...

a) Cultural exports are the commercial transfer of values and ideas from one country to another. Canned crab meat is a popular local fragility in Thailand and Viya Crab Products Co

What are the weaknesses of the traditional approach, What are the Weaknesse...

What are the Weaknesses of the traditional approach The traditional approach to the scope of finance function evolved during 1920s and 1930s and dominated academic during 40's

Define the explicit cost of capital, Define the Explicit cost of capital ...

Define the Explicit cost of capital Explicit cost of retained earnings that involve no future flows to or from firm is minus 100 per cent. This must not tempt one to infer that

Manage Budget and Financial Report, Complete the financial reporting for ea...

Complete the financial reporting for each period and develop recommendations using the templates provided. Procedure 1. Read the case study. 2. Complete the financial reports

Show the projected balance sheet method, Q. Show the Projected Balance Shee...

Q. Show the Projected Balance Sheet Method? Projected Balance Sheet Method: - Under this process an approximate is made of assets and liabilities for a future date and a projec

Credit enhancement of asset-backed security, Credit enhancement of an...

Credit enhancement of an asset-backed security implies the existence of support for one or more of the bondholders in the structure. Credit enhancement levels var

What are the rationales of interest swaps, Question: i) What are the ...

Question: i) What are the rationales of interest swaps? ii) You are the corporate treasurer of LSE International Inc. Your firm, rated as AAA, is able to raise capital in

Tax consideration affect cost of debt and cost of equity, How do tax consid...

How do tax considerations affect the cost of debt and the cost of equity? As interest on debt is tax deductible to the issuing firm, as much higher the tax rate the lower the aft

Determining optimum liquid balance, Q. Determining Optimum Liquid Balance? ...

Q. Determining Optimum Liquid Balance? Liquid balance (balance of cash and marketable securities) must be maintained at the optimum level. It is the level which gives the minim

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