Forward contracts, Financial Management

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Forward Contracts:

The origin of forward contracts is lost in history. Some authors suggest that, it was India where these contracts took birth, while some others suggest that Roman emperors employed forward contracts to procure foodgrains from Egypt. Irrespective of this fact, they are serving important social objectives in the present age. It is estimated that forward contracts worth $500 billion are being entered into every year.

Before the industrial revolution, it was not an easy task to export commodities from one country to another. The probability that the price could change drastically during the period the commodities were being transported, was high. Under these conditions, the traders required a mechanism where they could protect their price and the profits. One of the viable methods to achieve this objective was to enter into a forward contract with the other trader. That is, the trader had to search for another trader who was willing to take position in the contract as a buyer. This created the first real problem. In the real world, it is quite difficult to find two traders with similar requirements.

In forwards, both the traders negotiate the details of the contract privately without the intervention of a third party. No doubt, this facilitates the traders to draw the details of the contract according to their needs, but this also increases the probability that one of the traders might default on fulfilling his obligation. This characteristic of the forwards contract changes the very nature of risk, as the fulfillment of the contract depends on the worth of the counterparty. This is the second real problem that one has to put-up with, if he wishes to deal in forwards.

In forward contracts, since the producers are not in direct contact with the purchasers, they have to route their contracts through middlemen. Middlemen play a crucial role in forward markets, as they purchase the produce from the producer by entering into a contract and then enter into a second contract with the other purchaser regarding the supply of the same. They bear the risk and have to perform the other part of the contract even when one of the parties default.

Therefore, they should not only be paid for their services, but also for credit risks they bear.

Although this may not be a problem on the face of it, the presence of an institution will bring much more stability to the whole process. This is a prerequisite for the retail investors to participate in forward markets. The other positive effect of this arrangement will be that the transaction costs will be lowered to a great extent. If we assume that a baker and a farmer (who enter into a mutual understanding on their trades) negotiate the same somewhere outside the exchange, without any of the exchange rules regulating them, then it would be a perfect example of a forward contract.

Although forward markets have been serving the society at large, they are not without their pitfalls as seen above. Now, we shall look at futures and how they were structured to overcome these problems.

 


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