The Forward Contract: Bilateral, Customised and Unmargined

A forward contract binds two named parties directly to trade the reference asset on a later date at a price fixed today. Nobody stands between them, so each carries the other side of the promise for the whole term. Every term is negotiated rather than fixed by an exchange, nothing is posted at the start, and all of the money moves on one day at the end.

Two parties who want a price now for a transaction later can simply agree one. Agreeing that price is the whole idea, and a forward contract is that agreement with nothing whatever added to it. What has been left out matters more than anything put in: there is no exchange to standardise the terms, there is no party in the middle to replace the two promises with its own, and there is no collateral anywhere to stand behind them. Taken seriously, those three absences produce every property of a forward contract, including the one property that made somebody build the standardised version.

What does a forward contract bind each side to do?

Start with the promises. Everything else is decoration on top of them. The forward buyer must take delivery of a single unit on the agreed date and must pay the forward price for it. The forward seller must hand that single unit over on the same date and must accept that same price. There is no third clause hiding underneath. Each side is committed the instant the number is written down, and when the date comes round neither may back out of what it committed to.

Notice what that rules out. Neither party holds a right, a choice or an entitlement of any kind here. Neither may look at the price on the day, decide it has gone against them, and quietly step away. If the reference asset has collapsed, the forward buyer still buys at the agreed price. If it has doubled, the forward seller still sells at the agreed price. The arrangement is symmetrical in obligation even though it will be violently unsymmetrical in outcome. Carry that distinction carefully. The instrument that does hand one side a choice is a genuinely different animal and is covered separately.

Now the part readers routinely skip. Nothing at all moves on the day the agreement is struck. There is no premiumA sum handed over at the start to acquire a position. A forward contract carries none. paid to enter a forward contract. Neither side is buying anything from the other on that day. The two parties are exchanging promises, and promises are free to make. The agreement happens today and the money happens later, and on the day it is struck the position has cost nobody a single rupee. The absence is the design, not a gap in it.

Now the version visible from any street, and it repays a moment before any arithmetic starts. A household that has just fixed the price of next winter's firewood with the supplier down the lane has struck a forward contract. No wood has moved. No money has moved. Both sides have simply written a number down and agreed to be held to it. And yet something real has happened. If firewood is dearer in December that household is in a different position from the neighbour who agreed nothing, and if it is cheaper the household has bound itself to overpay. Nobody has bought anything yet. Everybody is committed.

Who stands between the two parties?

Nobody. The word bilateral carries exactly that much content, and it deserves unpacking rather than nodding at. Most of the consequences below begin there. There is no exchange in this arrangement. There is no clearing corporationThe institution that steps into a trade done on an exchange and becomes each side's replacement for the other. None is present in this arrangement. that has substituted itself for either promise. There is a forward buyer, a forward seller, and a line between them, and that is the complete structure.

Concretely, that means the forward buyer is carrying the forward seller by name for the whole term, and the forward seller is carrying the forward buyer by name for the whole term. Not carrying a market, not carrying an institution, not carrying an abstraction. Carrying one specific business, with one specific balance sheet, whose ability to perform on one specific day in the future is the only thing standing between the forward buyer and a worthless piece of paper. The word for that specific business is the counterpartyWhichever party happens to be standing at the far end of a signed agreement. The word points at one named business, not at a market., and on a forward contract there is no being vague about which business that is.

Followed through, a second property appears immediately. The forward buyer cannot close the position by dealing with somebody else. On an exchange, selling what was bought ends the matter. The party faced was never the party bought from in the first place. On a forward contract that route fails. The promise was made to one named business, and that business has not agreed to release anybody from it. There are exactly two routes out, and they are worth drawing because readers assume there is a third.

Route one is the unwindEnding an agreement early by getting the same party to agree it is over, rather than by handing it to somebody else.. Going back to the forward seller, both sides agree the arrangement is finished, and money changes hands to reflect whichever way the reference asset has moved since. An unwind requires the forward seller's consent. A party who has to want to give consent can charge for giving it. Route two is to strike a second, opposite forward with a third party. Economically the prices offset. Structurally things are worse rather than better. The second agreement leaves two parties who might fail, instead of one.

Feel this one from the street. A stall outside a single office building has agreed its whole winter stock with one supplier, at a fixed price, for delivery in November. The stall's agreement cannot be handed to the shop next door. The shop next door did not negotiate it and does not want it. And if the supplier shuts up shop in September, the agreement was worth exactly what the supplier was worth. The supplier turned out to be worth nothing. The stall did not lose money on the price. The stall lost the whole arrangement, and it lost it on a day when it had no time left to replace it.

What is negotiated, and what does the fit cost?

Everything is negotiated, and the word is meant literally. How much of the reference asset, what exactly counts as the reference asset for delivery purposes, on what date, delivered by what method, and against what security if any, are all decided between the two parties and written down by them. There is no template. There is no exchange publishing a specification that both sides simply accept. If the two of them want an odd quantity settling on an odd date, they can have it. The only two people who have to agree are already in the room.

Negotiating every term buys an agreement that fits the exact amount and the exact date somebody actually needs, with nothing left over. A business with a known payment falling due on the eleventh of a particular month can fix a price for exactly that day and exactly that quantity. Nothing has to be rounded to a lot size. Nothing has to be rolled because the nearest available date fell short. The fit is perfect because the fit was built to measure.

The fit costs the agreement its audience: nobody else wants it, so it cannot be handed on. The perfect fit and the dead end are not a benefit and a drawback sitting side by side. The two are one design decision seen from either end. An agreement built to one buyer's exact requirement is, by construction, an agreement that no second buyer needs, and the tighter the fit the smaller the pool of people who would take it on. Standardisation exists to create that pool, and it pays for the pool by making the fit approximate. One or the other is available; both together are not.

One routing note before the arithmetic. Where the reference asset is a currency or a rate rather than a physical thing, the arrangements under which such a bilateral agreement may be entered into at all are set by the Reserve Bank of India at rbi.org.in. The arrangements move. Each such requirement is set out below beside the authority that settles it.

The Forward Price: where does Rs 2,130.00/- come from?

The forward price is built rather than quoted, and the build runs below so that no such number need ever be accepted on trust again. Three inputs and no more. The reference asset costs Rs 2,000.00/- for delivery now, and that figure is a price. Financing costs 6.50 per cent a year, and the period matters as much as the number. And across that year the reference asset returns nothing whatever to whoever is sitting on it. The absence belongs in the same breath as the other two inputs. A payment reaching a holder would change the answer.

Now reason about what somebody with the reference asset in a year would have had to do. Anybody wanting it could buy it today at Rs 2,000.00/- and borrow the money to do it. Apply 0.065 to Rs 2,000.00/- and a year of financing weighs Rs 130.00/-. Set that weight back on top of the Rs 2,000.00/- they started from, and having the reference asset in hand a year from now has cost them Rs 2,130.00/-. So Rs 2,130.00/- is the forward price, and it is a price rather than a premium, a payoff or a profit.

Now the test that shows why it has to be that number rather than a nearby one. Suppose a forward seller offered to sell forward at Rs 2,100.00/-. Anybody could then borrow Rs 2,000.00/-, buy the reference asset today, hold it for the year, deliver it into that agreement, collect Rs 2,100.00/-, and repay a loan that has grown to Rs 2,130.00/-. The assembly leaves them Rs 30.00/- short, so nobody does it in that direction. Turn it round: the party who assembles the position for Rs 2,130.00/- and delivers it into an agreement struck at anything above Rs 2,130.00/- pockets the difference for certain, with no view about the reference asset required. A forward sale struck beneath Rs 2,130.00/- makes a present of the shortfall to whoever runs that assembly, and the gift is the entire reason the number sits where it does. The word for that assembly is arbitrageAssembling one position out of cheaper parts and delivering it into a dearer promise, so a difference is pocketed without waiting to see what happens., and it is the reasoning rather than the term that does the work here.

1. Borrow Rs 2,000.00/-for one year, with financing at 6.50 per cent a year.
2. Buy the reference asset todayat its spot price of Rs 2,000.00/-, and hold it. The reference asset hands its holder nothing during the year, so nothing comes back in.
3. Deliver it on the agreed dateinto the forward that was sold, and collect the forward price.
4. Repay the borrowing.The loan has grown to Rs 2,130.00/-. If the forward price was Rs 2,130.00/- the position is exactly square, and it was square from the day it started.

The forward price is a cost, not an opinion. The difference between a cost and an opinion carries a good deal of the rest of this subject. Not one of the four steps above required anybody to hold an opinion on the direction the referenced thing is travelling in. Nobody was asked what they expected. Nobody was asked what they hoped. The number came out of a borrowing rate and a purchase price, and it would be the identical number if every party involved were privately certain that the reference asset was about to halve.

Why can the forward price never sit below the spot price here?

Because of one property of the reference asset, stated more than once already. Across the whole year this reference asset returns not one paisa to whoever holds it, so holding it throws off nothing that could be set against the financing, and the carry is therefore positive at every financing rate above nil. Take the build apart again and look for the subtraction. There is no subtraction. There is a spot price and there is a financing cost, and the second is added to the first. A quantity that is only ever added cannot make the total smaller than the thing it was added to.

One thing could flip the arithmetic, and it is worth naming plainly. If the reference asset paid something to its holder during the year, that payout would subtract from the carry, and a payout large enough to exceed the financing would put the forward price below the spot price. The holder would be compensated for holding, rather than only charged for it. Nothing about that case is exotic or unusual, and readers meet it constantly in the world.

How Forward Contracts Work: what happens between the day it is struck and the day money moves?

Three moments, and nothing whatever between them. Three moments are the honest summary of the whole life of a forward contract. Readers who have met the exchange traded kind first arrive expecting activity that never comes, and find the emptiness genuinely surprising.

Moment one is the day of agreement. The forward price of Rs 2,130.00/- is fixed and written down. Nothing moves. No cash, no reference asset, no collateral, no record of value anywhere. Moment two is the entire stretch in between, however long it runs, and the thing to understand is that it is empty. The reference asset can travel wherever it likes. The agreement is not revalued. Nothing is collected from the side that is behind and nothing is paid to the side that is ahead. Moment three is the final date, and the whole of the arrangement executes at once: the forward buyer pays Rs 2,130.00/- and the forward seller delivers one unit of the reference asset, or the two settle the difference in cash if that is what they negotiated.

Sitting in that empty stretch is an unrecorded and uncollateralised gain on one side and an exactly equal loss on the other, and the gain grows as the reference asset moves away from Rs 2,130.00/-. The forward buyer struck at Rs 2,130.00/- with the reference asset now at Rs 1,600.00/- is behind by Rs 530.00/-. Nothing has recorded that. Nothing has collected it. The forward seller who is ahead by exactly Rs 530.00/- has received nothing and has no claim on anything until the final date arrives. Both facts are simply sitting there, agreed and unactioned.

Here is the consequence almost no reader reaches unaided: the bigger the move, the more the losing side owes, and therefore the more reason that side has not to perform, and nothing whatever in the arrangement pushes back on that. The risk is not merely present. The risk is correlated with exactly the circumstance in which it would matter. A small move leaves a small obligation that anybody could meet. A large move leaves a large obligation, concentrated on whichever party is least able to meet it precisely because the same move has probably hurt them elsewhere too. The correlation is why somebody eventually built the standardised, cleared and margined version of this agreement, and that version is covered separately.

What is posted, and what follows from posting nothing?

Nothing is posted. The word for that is unmargined. The word gets used so casually that its two consequences are rarely held together, so it is worth saying plainly before unpacking it. No collateralCash or securities parked with somebody else so that a promise has something behind it if the promise is broken. is lodged by either side at the start, none is lodged as the reference asset moves, and none is topped up when one side falls behind.

The first consequence is that no cash leaves either party before the final date, so the arrangement costs nothing at all to carry. Costing nothing to carry is a genuine advantage, and it is why plenty of businesses use exactly this shape. A business that has fixed a price for a payment falling due next year has not had to find any money to do it. Its working capital is untouched. Nothing sits idle in an account somewhere waiting for a date that has not come.

The second consequence is that nothing stands behind the promise, so the whole of the risk is the other party's ability and willingness to perform on one day. There is no buffer. There is no fund. There is nobody who has already taken the money and would pay out of it. There is a signature and a business, and the value of the first depends entirely on the health of the second on a date that may be a year away.

The two consequences are one design decision seen from two sides, and the standardised version of this contract, covered separately, is simply what results when somebody refuses to accept the second in exchange for giving up the first. Read together, the trade is obvious. Post nothing, and the counterparty is carried. Post something, and the cost of posting it is carried. There is no arrangement in which neither is carried, and the whole of the next stretch of this subject is an examination of what the second choice actually looks like when it is engineered properly.

Who actually uses this, and what do they do with it?

Three seats, and it is worth being concrete about each. The shape looks abstract until somebody is seen handling it.

The first seat is a business with a known future payment. Its problem is not that it wants to take a view on the reference asset. Its problem is precisely the opposite. It wants to stop having a view at all. A business with no view can quote a price to its own customers and not be embarrassed by a move it did not choose. A bilateral forward fixed at the exact quantity and the exact date removes the uncertainty completely. The forward introduces in exchange a named party who has to be there on the day, and a good treasurer treats that substitution as the actual decision rather than as a formality attached to it.

The second seat is a lender or a credit team looking at a business that has forward contracts on its books. The credit team is not asking for today's value of the position. The credit team is asking how large the unrecorded obligation could get, and who is on the other end of it. An uncollateralised forward is a credit exposure dressed as a price agreement, and the credit question is the one that decides whether it matters. Two words earn their keep in that seat. A forward for forty units at Rs 2,130.00/- carries a notionalThe headline size an agreement is measured against. The notional scales what is owed; it is not a sum anybody hands over. of Rs 85,200.00/-, a sum that stays entirely on paper and reaches nobody's bank account. The exposureHow much of the referenced thing a promise actually moves with, priced at what that thing is worth now. that moves with the reference asset is forty units at the current Rs 2,000.00/-, or Rs 80,000.00/-. Reporting one of those and calling it the other misdescribes the arrangement by Rs 5,200.00/- while sounding entirely precise.

The third seat is an analyst reading a forward price out of somebody's disclosure. The temptation is to write down that the price implies a view, and the disciplined move is the one in the reading routine below: carry the spot price at the financing rate for the period and see whether the gap is already fully accounted for. If it is, there is nothing left over to interpret, and the correct sentence in the note is that the arrangement is priced at carry rather than that anybody expects anything.

How to analyse a Forward Contract: which questions, and in what order?

Six questions in a fixed order. The order matters more than it looks. Each answer narrows what the next question can mean, and taking the six out of order is how people end up interpreting a price before they know what it is a price of. No mechanism is explained by the routine. The six questions are a reading procedure, and everything they need has already been built above.

Question four is the one nobody performs, so it gets the arithmetic spelled out. An agreement arrives at Rs 2,130.00/- while the reference asset stands at Rs 2,000.00/-. The gap is Rs 130.00/-. Dividing Rs 130.00/- by the Rs 2,000.00/- it was struck on gives 0.065, or 6.50 per cent for the year. The 6.50 per cent is the rate the agreement has embedded in it, and reading it out is the difference between checking a forward price and simply believing one.

The rate read out is good for two things. If the rate read out is roughly what money costs the party concerned, the agreement is priced at carry and there is nothing further to interpret. If it is materially different, something real has been learned: either the reference asset is not what was assumed, or the agreement contains something other than plain financing, or somebody has quoted a price nobody would run the four steps against. Any of those is worth knowing, and none of them is available to a reader who never divided.

Who sets the terms left blank here?

Should anybody enter one of these?

The question is not one the arithmetic can settle. Four things would have to be on the table before anybody could answer it: what the position exists to do, what is already being held against it, who is standing on the far end, and what lands on whichever side is wrong on the day the money moves. Not one of the four is knowable from here, and three of them are properties of the reader rather than of the contract.

Following the arithmetic above is not a reason to go and sign one of these. Understanding how an agreement is put together and deciding to be a party to it are two entirely separate activities, and only the first has been performed here.

The reference asset, its Rs 2,000.00/- spot price, the 6.50 per cent a year it costs to finance and both parties to the agreement are invented.
Educational material. Not advice on any investment, tax, budget or market position.