Introduction to forward contracts

A forward contract is a customized, over‑the‑counter (OTC) agreement between two counterparties to buy or sell an underlying asset at a predetermined price on a specified future date.

The buyer commits to purchase, and the seller commits to deliver, the asset regardless of the market price at maturity. Because the contract is private, its terms – such as quantity, delivery date, and settlement method – can be tailored to the needs of the participants.

In the Indian context, forwards are commonly used for equity indices (e.g., NIFTY), individual stocks, and currency pairs. SEBI classifies them as “derivative contracts” and requires that brokers disclose the credit risk associated with OTC exposure.

• Customization – Parties negotiate all terms.
• No daily marking‑to‑market – Profit or loss is realised only at settlement.

Forward contracts are traded exclusively OTC, meaning they are not listed on any exchange. This lack of a central marketplace eliminates the need for margin or daily cash flows, but it introduces counter‑party credit risk.

Because the contract is settled only once – at maturity – there is no marking‑to‑market. The parties must therefore assess the creditworthiness of each other and may require collateral or a credit support annex (CSA) to mitigate default risk.

Forwards can be settled either physically (delivery of the underlying shares) or in cash (difference between forward price and spot price). The choice is usually stipulated in the contract and influences tax treatment under Indian law.

• OTC nature – No exchange‑based price transparency.
• Credit exposure – Managed through collateral agreements.

The forward price reflects the cost of carrying the underlying asset from today (time 0) to the delivery date (time T). Carry costs include financing (risk‑free interest), storage, and any income earned from the asset, such as dividends. In equity forwards, the dividend yield is treated as a benefit that reduces the forward price.

Mathematically, the model is expressed as spot price multiplied by the exponential of the net carry cost over the contract’s life. Continuous compounding is the standard convention in the NISM syllabus because it simplifies the relationship between rates and time.

Understanding each component – risk‑free rate (r), storage cost (u), and convenience yield or dividend yield (y) – is essential for answering pricing and valuation questions, especially when the exam presents a change in any one of these inputs.

The forward price moves in tandem with the spot price because the spot is the base of the cost‑of‑carry formula. Any rise in the spot immediately raises the forward, all else equal.

Interest rates are a major driver. A higher risk‑free rate increases the financing cost, pushing the forward price above the spot. Conversely, a higher dividend yield reduces the forward price because the holder forgoes dividend income.

For equity forwards, storage costs are typically negligible, but for commodity forwards (e.g., gold) they become significant. The net effect is captured by the term (r + u - y).

• Spot price (S0) – Directly proportional to forward price.
• Risk‑free rate (r) – Higher r → higher forward.
• Dividend yield (y) – Higher y → lower forward.

When a forward contract is already in place, its value at any intermediate time (t) is the present value of the difference between the current forward price for the remaining maturity and the originally agreed forward price.

Mathematically, the value V_t = (F_{t} - K) \times e^{-r(T-t)}, where K is the original contract price, F_{t} is the forward price calculated at time t for the remaining period, and r is the risk‑free rate.

Because forwards are not marked‑to‑market daily, traders must compute this value to assess profit or loss, to decide on early termination, or to manage credit exposure.

• Positive value – Current forward price > original price.
• Negative value – Current forward price < original price.

SEBI’s “Derivatives Market Regulations” require that brokers disclose the exposure arising from forward contracts and maintain adequate capital to cover potential losses. While forwards are not exchange‑traded, they fall under the broader derivative reporting obligations.

From an accounting perspective, Indian GAAP treats forward contracts as financial instruments. At inception, no entry is recorded. Subsequently, the contract is re‑measured at fair value, and any unrealised gain or loss is recognised in the profit and loss statement.

For tax purposes, gains from forward contracts on equity indices are taxed as capital gains, with the holding period starting from the date of contract initiation. This nuance is frequently examined in scenario‑based questions.

Memorise the forward‑price formula and the meaning of each variable; a quick substitution often yields the answer.

When a question provides spot price, interest rate, dividend yield, and time, plug them directly into the cost‑of‑carry model – do not try to approximate with simple interest.

Watch out for distractors such as storage cost for equities (usually zero) and for the distinction between continuous and discrete compounding. The NISM syllabus assumes continuous compounding unless explicitly stated otherwise.

Finally, always read the contract specifications: physical vs. cash settlement, and whether the forward is on an index or a single stock, as these affect dividend treatment and tax implications.