Definition of Forward Contract
Forward Contract is a binding agreement between parties to exchange a set of amount of goods at a set future date at a price agreed today. This is the contract which allowed to set a price of a commodity in advance.
In a Forward Contract, both parties will agree to abide the terms and conditions and to make the settlement in a future as today’s pre-agreed price as mentioned in the agreement.
The importer and exporter considered it as one of the safest hedging methods for their transactions because it may help to protect them from future adverse price movements. Forward exchange contracts allow importer or exporter to hedge their commodity price by sell or buy a quantity of foreign currency at a future date, at a rate when the forward contract is made. Here bank plays the main role in this contract.
The main advantages of forward contract is the trader will know how much local currency he will receive or he will pay. The current spot price is irrelevant to the outcome of a forward contract.
Features of Forward Contract
The basic features of forward contract are as follows:
A Forward Contract is a bilateral contract that is exposed to counterparty risk.
Riskier than a future contract:
There is a risk of non-performance of the contract. Hence, these are riskier than future contracts.
Each contract is custom designed, and hence it is unique in terms of contract size, expiration date, the asset type, quality etc.
Specific Delivery Price:
The specified price in a forward contract is referred to as the delivery price.
Example of Forward Contract
An importer of U.K. knows on 1st July, he must pay a foreign seller $ 36,500 in one month’s time, on 1st August. He arranges a forward exchange contract with his bank on 1st July, whereby the bank undertakes to sell the importer $ 36,500 on 1st’ August at a fixed rate, say, 1.20 to the sterling.
In these cases, the importer of U.K. can be certain about his payment, whatever the spot rate move to at 1st August. He will have to pay against product price = 36,500/1.20 = Sterling 30,416.16.
- If the spot rate is lower than 1.20, the importer would have successfully protected himself against a weakening of the sterling (strengthening of the $) and would have avoided paying more sterling to obtain the US dollar. Say, at 1st August Spot Rate is 1.10. Normally 36,500/1.10 = 33,819 would have to pay on 1st August. But the company will pay 30,416 due to forward contract. Net savings is (33,819 – 30,416) = Sterling 3,403
- If the spot rate is higher than 1.20, the importer would pay more under the forward exchange contract than he would have to pay if he had obtained US Dollar at the spot rate on 1st August. He can not avoid this extract because of forward contract as this is a binding agreement. Say, at 1st August spot rate is 1.30. Normally 36,500/1.30 = 28,077 would have to pay on 1st August. But the company will pay 30,416 due to forward contract. Net loss in this case = (30,416-28,077) = Sterling 2,339.
Accounting Entries of Forward Contract
Following Journal entries to be passed for forward contract agreement
In the Books of buyer:
A) When an agreement is made:
Debit Asset Receivable A/c
Debit Premium on Forward contract
Credit A/c Payable (supplier A/c)
B) On the Maturity of Forward Contract date:
On the maturity date, the current market price will be calculated. This price (current market price) will compare with future price. The difference arises from it will be treated as either loss or gain on the forward contract.
i) When assets is received:
Debit Assets (purchase) A/c
Debit Loss on forward Contract A/c
Credit Gain on forward Contract A/c
Credit Premium on forward contract A/c
Credit Assets Receivable A/c
ii) When payment is made:
Debit A/c Payable
Credit Bank / Cash A/c
2. In the Books of Seller:
(A) on the agreement Date:
Debit A/c Receivable
Credit Asset Obligations A/c
Credit Premium on Forward Contract A/c
(B) On the Maturity of Forward Contract Date:
i) When Assets transferred to buyer:
Debit Assets Obligation A/c
Debit Loss on forward contract A/c
Debit Premium on forward contract A/c
Credit Gain on forward contract A/c
Credit Assets Sale A/c
ii) Payment is received:
Debit Cash/ Bank A/c
Credit A/c Receivable
What happens if the customer cannot satisfy a forward contract?
A customer may not be satisfied with the forward contract-
- When an importer found that his supplier fails to deliver the goods as specified in contract, customer may not agree to pay.
- When the supplier sends fewer goods than specified in the contract, the importer may pay less amount.
- When the supplier is late with delivery of goods, the customer may refuse goods or recover the loss from the supplier for his late supply.
Entering into a forward rate agreement (FRA) with a bank allow the customer to lock in the interest rate or price of the product for the time as specified in the agreement. This agreement is independent upon which the prevailing rate will be paid. In case of the loan, if FRA rate of the loan is lower than the spot rate, the bank will pay the differential amount and if FRA rate is higher than the spot rate, the customer will pay to bank the difference amount as FRA is a binding agreement.