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What is a forward contract?
A forward contract is a non-standardized, unregulated, over the counter, customizable deal between 2 entities. It is like the Future contract as both parties honor the deal by exchanging cash or the underlying asset at price agreed upon. Though forward contracts are risky as they are not traded on the exchange. Let’s discuss an example right away.
A farmer cultivates an apple and sells it in the open market. A pie chain buys apples in a bulk deal from the open market. The market being volatile, both parties fear losses. If the price goes very high, farmers will gain and the pie chain will lose a lot of money and vice versa. To save themselves from this loss, they both can agree on a contract. Let’s say the farmer’s total cost involved is 100 per kg. If the price goes to 200, the farmer will gain 100 per kg. If the price drops 90–120 per kg, he will be in a loss. So, both parties can decide on a deal where the farmer will cultivate apples and after they are done, he will sell them to the pie chain for 150 Rs per kg. Irrespective of the market price might be.
If the future price goes to 180/kg, the Pie chain can profit 20/kg, but the farmer has got insured 150/kg with which he can take care of all expenses. So, it works for both parties to some extent.
If price > 150, farmers will pay the pie chain the difference.
If price < 150, the Pie chain will pay the farmer the difference. (Given the exchange happens with then market prices and contract cover the volatile price)
A forward contract can prove good for commodity deals. Forward contracts are still unregulated, and there is default risk involved.
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