Forward Contract

Forward Contracts (forwards) have flourished for many centuries in many countries. It is the simplest of all derivatives. A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price. 

It is a one to one bipartite contract, which is to be performed in the future at the terms decided today. One of the parties in the forward contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified period. The other party assumes a short position and agrees to sell the asset on the same date at the same price. Let us understand the concept with the help of an illustration.

Two parties enter into a contract to buy and sell 100 shares of Reliance at Rs 850 per share, two months down the line from the date of the contract. Assume A is the buyer and B is the seller. In the instant case, the product (shares of Reliance), quantity of product (100 shares), product's price (Rs. 850 per share), and time of delivery (2 months from the date of the contract) have been determined and well understood, in advance by both the parties concerned. The delivery and payment (settlement of the trade) will take place as per the terms of the contract on the designated date and place.

But there could be risk of default here, suppose the Reliance's price two months down the line goes up substantially, seller B would prefer to sell the share the markets rather than selling these shares to A as contracted; because, market would fetch him better price. Therefore he may default. Similarly, in case, price of Reliance goes down, buyer may choose to default because he  may find he would find it attractive to buy Reliance share from the market at lower price, instead of honoring the contract. This  way, both A and B are exposed to each other's risk of default.