Understanding Forward Contracts: How They Work and Why They're Used

A forward contract is a private, customizable agreement between two parties to buy or sell an asset at a fixed price on a future date. They work by establishing a predetermined price today for a transaction that will occur later, with the goal of hedging against future price fluctuations and locking in a cost or revenue.

A forward contract is a non-standardised, over-the-counter (OTC) agreement between a buyer and seller to execute a transaction at a future date for a pre-agreed price.

There is no involvement of a stock exchange or clearing house, and the terms—price, quantity, expiration date—are negotiated diretcly between the parties.

These features make forward contracts suitable for institutional or corporate use.

Consider how forward contracts function through an example scenario.

Example Scenario

A coffee exporter expects to ship 10 tonnes of coffee three months from now. To protect against a fall in coffee prices, the exporter enters into a forward contract with a buyer to sell the coffee at ₹200 per Kg after three months.

• Forward Price: ₹200/Kg
  

• Quantity: 10 tonnes (10,000 Kg)
  

• Delivery Date: 3 months later
  

• Total Contract Value: ₹20,00,000
  

Regardless of the market price three months later, the exporter will sell at ₹200/Kg.

Forward contracts can be settled in two ways:

Physical Settlement

The actual asset is delivered to the buyer, and payment is made as per contract terms.

Cash Settlement

No actual delivery occurs. Instead, the difference between the contract price and market price is paid by the party at a disadvantage.

These are particularly popular among exporters, importers, banks, and institutional investors.

• Commodities (e.g., oil, wheat, gold)
  

• Currencies (e.g., INR/USD, EUR/INR)
  

• Interest Rates (using FRA - Forward Rate Agreements)
  

• Equity Shares or Indices (in OTC arrangements)

While both allow hedging and speculation, futures might offer more transparency and lower default risk.

Forward contracts are commonly used in business environments where managing cost certainty is critical. Here's why they play a key role:

Hedging Price Risk

Businesses use forwards to lock in costs or revenue. For instance, an airline might hedge against rising fuel prices.

Predictability

They provide certainty regarding cash flows and pricing, helping in budgeting and financial planning.

Flexibility

Customisation allows parties to tailor terms based on specific needs—something exchange-traded instruments can’t offer.

Currency Risk Management

Importers/exporters use forward contracts to fix exchange rates in advance, safeguarding against currency volatility.

It is advisable to assess counterparties’ financial stability before entering such contracts.

In India, forward contracts are commonly used in:

• Foreign exchange markets (especially by exporters/importers)
  

• Agricultural commodity trades (e.g., sugar, cotton)
  

• Corporate treasury operations
  

• Interest rate hedging by large institutions
  

They are facilitated by banks and authorised dealers under RBI guidelines, especially in currency forwards.

Here’s when using forward contracts becomes a smart risk-management move:

• When future cash flows are sensitive to price or currency changes
  

• During long negotiation periods where fixed pricing is required
  

• When operating in global supply chains impacted by forex volatility
  

• To lock input/output prices in contracts with narrow margins
  

Forward contracts should be used strategically, not speculatively.

Forward contracts help hedge against pricing and currency risks in business. Their flexibility suits firms with specific cost exposures, but higher counterparty risk means they should be used cautiously and with proper legal checks. They're best seen as risk management tools—not for speculation.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.