Forward Contracts are an agreement wherein a buyer is obliged to purchase and a seller is obliged to sell a specific quantity of a specific asset at the contracted price on an agreed future date.
Assets in Forward Contract
The contract could be for foreign currencies, metals, agricultural products, commodities, financial instruments, electricity, etc. These contracts are private agreements that are not executed or traded on any exchange, and therefore, in case of a default, there is no structured remedy.
Mechanics
Such contracts lock-in the future price and the contract has mandatorily to be performed by the buyer and the seller. Assume that X, an exporter, is expecting a remittance of USD 10,000 on June 15, 2016. The INR/USD exchange rate today is Rs.65/- and, on that basis, the remittance is worth Rs.6.50 lakh. Being unsure of the rate that would be prevailing on June 15, 2016, X enters into a forward contract for sale of USD 10,000 with his Bank at INR/USD Rs.65/-. Now he is assured of earning Rs.6.50 lakh from the remittance and the liability of the Bank is restricted to that amount. If on June 15, 2016, the INR/USD rate is Rs.66/-, X will be entitled to only Rs.6.50 lakh from his Bank which itself will receive Rs.6.60 lakh.
Importance
Forward contracts are a via-media to protect oneself against unexpected fluctuations in prices.
Forward contracts just help to avoid any uncertainty in the future cash flows.The seller knows how much will be getting and buyer also knows how much exactly he will be shelling out.One more advantage would be that there is absolute certainty of payment.However there is downside for the seller when the exchange rate or market rate increases at the time of honoring the forward contract.