The basic features of a forward contract are explained below:
Forward contracts are bilateral contracts, and hence, they are exposed to counterparties’ risk. There is a risk of nonperformance of the obligation by either of the parties, so these are riskier than futures contracts.
Each contract is custom designed and hence, is unique in terms of contract size, expiration date, asset type, quality, etc.
Long and Short Position
In a forward contract, one long position is by agreeing to buy the asset at a certain specified future date.
The other party assumes a short position by agreeing to sell the same asset at the same date for the same specified price.
A party with no obligation offsetting the forward contract is said to have an open position.
A party with a closed position is sometimes called a hedger.
The specified price in a forward contract is referred to as the delivery price.
The forward price for a particular forward contract at a particular time is the delivery price that would apply if the contract were entered into at that time.
It is important to differentiate between the forward price and the delivery price. Both are equal at the time the contract is entered into.
However, as time passes, the forward price is likely to change, whereas the delivery price remains the same.
In the forward contract, derivative assets can often be contracted from the combination of underlying assets; such assets are often known as synthetic assets in the forward market.
Settlement by Delivery on Expiration Date
In the forward market, the contract has to be settled by delivery of the asset on the expiration date.
In case the party wishes to reverse the contract, it has to compulsory go to the same counter-party, which may dominate and command the price it wants as being in a monopoly situation.
In the forward contract, covered parity or cost-of-carry relations are relations between the prices of forwarding and underlying assets.
Such relations further assist in determining the arbitrage-based forward asset prices.
Forward contracts are very popular in the foreign exchange market, as well as interest rate-bearing instruments.
Most large and international banks quote the forward rate through their ‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange quotes by these banks are displayed with the spot rates.