Basics of Forward Contract - Derivatives Market
Forward contract is an agreement signed on X date and the maturity date is (X+Y) i.e. 1 week, 1 month, 3 months or, 6 months. A forward contract is an OTC (Over the Counter) product. This contract gives the right to underlying assets which both the parties would and thereto in the best of faith, not in compulsion. A forward contract is generally not a structured product and terms of contract are negotiated by both the parties.
Exchange facilitates Over the Counter (OTC) contracts between two parties and own commission on execution of the contract. It also ensure that the contract is honored by charging margin to both the parties and remove opportunity cost.
E.g. - NCDEX, MCX
Margin is the minimum amount to be paid by a party to sign a forward contract.
Contract Value :
It is a equal to product of number of lots signed between the two parties and the price at which contract is signed.
Lot Size :
Lot size ia a minimum quantity of an underlying asset for which a contract is signed.
Expiry Date :
It is a date on which the contract is to be executed. i.e. exchange of goods occur.
ITC Company wants to purchase a wheat after 6 months for its floor mill. It fears that the price of wheat may increase after 6 months which may put pressure pressure on its margin.
A farmer has about 1000 tons of wheat which he will get after 6 months during the harvest season. The farmer fears prices of wheat will go down.
Both the farmer and ITC company enters into a forward contract for 6 months at current market price Rs 30 per kg.
Contract Value = 30X1000X1000=3,00,00,000 (1 ton = 1000 kg)
A farmer is tempted after 6 months to default on the contract if price of increases to Rs 35 per kg OR #ITC is incentives to dishonored the contract if the price of wheat fall to Rs 25 per kg.
To avoid the either of these situation, both parties are require to pay a margin which nullifies the opportunity cost.
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