Here are some key points about forward contracts:

• Customized: Forward contracts are tailored to meet the specific needs of the buyer and seller.

• Over-the-counter (OTC): Forward contracts are traded outside of formal exchanges, directly between two parties.

• No exchange fees: Since forward contracts are OTC, there are no exchange fees involved.

• No marking-to-market: Forward contracts are not marked-to-market, meaning that gains or losses are not realized until the contract expires.

• High counterparty risk: Forward contracts carry high counterparty risk, as the contract relies on the creditworthiness of the other party.

Forward contracts are commonly used in various markets, including:

• Foreign exchange (FX): To hedge against exchange rate fluctuations.

• Commodities: To lock in prices for raw materials or goods.

• Interest rates: To manage interest rate risk associated with borrowing or lending.

By using forward contracts, businesses and investors can manage price risk and uncertainty, securing a fixed price for an asset in the future.

An example of a forward contract! You've correctly outlined the key details:

• Asset: Apples

• Price: Rs. 100 per kilo

• Quantity: 500 kilos

• Delivery date: Three months from now

Forward contracts are indeed customized agreements between two parties, and they rely on the creditworthiness and commitment of both the buyer and seller.

Regarding the risk you mentioned, it's true that forward contracts carry counterparty risk. If one party defaults or refuses to fulfill their obligation, the other party may face losses. In your example, if the farmer fails to deliver the apples or the fruit dealer refuses to pay, the affected party may need to seek legal action or negotiate a settlement.

To mitigate this risk, parties may consider:

• Collateral: Requiring a deposit or collateral to secure the contract

• Penalty clauses: Including provisions for penalties or damages in case of default

• Reputation and trust: Dealing with reputable and reliable counterparties

• Legal agreements: Having a comprehensive and legally binding contract

It's important for both parties to carefully consider the terms and risks involved in a forward contract and to have a plan in place in case something goes wrong.

An example of how forward contracts can occur in our daily lives without us even realizing it!

In this scenario, you and the jeweler have entered into a forward contract, where:

• Asset: Gold coins

• Price: The current market price (agreed upon today)

• Delivery date: Five days from now

• Quantity: Not specified (but implied as the amount you want to purchase)

By agreeing to deliver the gold coins at the current price in five days, the jeweler has effectively entered into a forward contract with you. This contract binds them to deliver the gold coins at the agreed-upon price, regardless of any potential price changes in the market.

As you mentioned, this is a "Gold forward contract", and it's a common example of how forward contracts can be used in everyday life, even outside of formal financial markets.

Other examples of forward contracts in daily life might include:

• Real estate: Agreeing to buy or sell a property at a set price on a future date

• Car purchases: Ordering a car with a specific configuration and price, with delivery promised for a later date

• Home renovations: Contracting with a builder to complete work at a fixed price, with payment due upon completion

In each of these cases, the parties involved are essentially entering into forward contracts, agreeing on the terms of the transaction, including price, delivery date, and other conditions.

Four crucial points about forward contracts, specifically in the context of your gold coin purchase:

1. Seller's obligation: The seller is bound to deliver the gold coins on the agreed-upon future date at the specified price.

2. Buyer's obligation: As the buyer, you are committed to purchasing the gold coins on the agreed-upon future date at the specified price.

3. Counterparty risk: Since this is a private contract outside of a formal exchange, there is a risk that the other party (seller or buyer) may default on their obligations.

4. Advance payments: While not typically required, advance payments or margin money can still be made, but it's not a standard practice in forward contracts.

These points emphasize the importance of understanding the terms and risks involved in forward contracts, even in everyday transactions like buying gold coins.

An example of what if there is a fall in the price of gold? 

If the price of gold falls within five days, the seller stands to gain, and if the price rises, you, the buyer, would benefit. However, since forward contracts are binding, the agreed-upon price must be honored, regardless of any price changes.

The lack of regulation in forward contracts means that there is a risk of default by either party if the market moves against them. This is indeed known as counterparty risk, which is inherent in all forward contracts.

Counterparty risk is the risk that the other party in the contract will fail to fulfill their obligations, which can result in financial losses. In this example, if the price of gold drops, you may be tempted to default on the contract, while if the price rises, the seller may be tempted to default.

Both parties need to understand the risks involved in forward contracts and to have a plan in place to mitigate them. This can include setting clear terms, securing collateral, or establishing a reputation for reliability.

SETTLEMENT 

Settlement is a crucial aspect of forward contracts. Since forward contracts are OTC contracts, they are settled directly between the two parties involved, without going through a centralized exchange.

At the end of the contract period, settlement can happen in two ways:

1. Physical settlement: The actual delivery of the asset (e.g., gold coins) takes place, and payment is made in cash.

2. Cash settlement: The parties settle the difference in cash positions, without physical delivery of the asset.

In both cases, the goal is to settle the contract by fulfilling the obligations agreed upon in the contract.

Physical settlement involves the actual exchange of the asset for cash, while cash settlement involves a cash payment based on the difference between the contract price and the market price at the time of settlement.

It's important to note that forward contracts can be tailored to meet the specific needs of the parties involved, and the settlement terms can vary accordingly.

An example that illustrates how forward contracts can be used to manage price risk in agricultural commodities like mangoes.

The mango farm owner and the mango pulp processing company have entered into a forward contract, agreeing on a price of Rs. 30,000 a ton (or Rs. 30 a kg) for 10,000 tons of mangoes to be delivered three months from now. This contract locks in the price for both parties, regardless of any potential price fluctuations in the market.

By entering into this forward contract, both parties have achieved their goals:

• The mango farm owner has secured a fixed price for his mangoes, eliminating the risk of a potential price drop due to a bumper harvest.

• The mango pulp processing company has ensured a stable supply of mangoes at a fixed price, maintaining its profit margins without worrying about potential price increases.

As you mentioned, the actual market price of mangoes three months from now is irrelevant, as the parties have already agreed on the forward price. This contract has effectively hedged the price risk for both parties, allowing them to plan and budget accordingly.

Forward contracts have some drawbacks:

1. Lack of standardization: Each forward contract is customized, which means that the terms and conditions, such as quantity, payment mode, delivery date, and price, can vary greatly from one contract to another.

2. Counterparty risk: As you mentioned, the performance of forward contracts is not guaranteed, and there is a risk that one party may default on their obligations.

3. No centralized exchange: Forward contracts are traded over-the-counter (OTC), which means that there is no centralized exchange to regulate or guarantee the contracts.

4. Liquidity risk: Forward contracts can be illiquid, making it difficult to exit a contract before maturity.

5. Legal risks: Forward contracts are subject to legal risks, such as disputes over contract terms or non-performance.

These drawbacks highlight the importance of carefully considering the terms and risks involved in forward contracts and ensuring that both parties have a clear understanding of their obligations and commitments.