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Legal Nature of Forward Contracts

March 29, 2012 | Comments: 0 | Views: 152

The forward contract constitutes a legally binding agreement between two counterparties for provision of "financial service". Forwards are derivative financial instruments; their profitability depends on the value of other financial assets ("underlying securities"). Forward contracts can be used as a powerful investment tools or for hedging and speculation purposes.

The subject matter of forward contract must be purchase or sale of a specified underlying asset at some time in the future at a certain (preagreed) price (supply cost, forward price). The underlying assets may be goods, manufacturing raw materials, financial instruments (securities, currencies, values of stock indices, interest rates, etc.) with mutually agreed parameters in terms of quantity, price and delivery time.

Unlike futures, forwards are not standardized contracts and they are not traded on an organised market (exchange). One of the most essential differences between futures and forwards is that futures contracts are standardized. Their terms and conditions are not negotiable; only the price is agreed through bidding. These characteristics of futures contracts acts to some extent as a disincentive for investors, who need to find the right contract and assess whether it meets their needs, and this may costs time and money. The forward agreement can contain non-standard terms and conditions. This allows the conclusion of an agreement, which is more precisely aligned with the requirements of both parties and this way the transaction is more effective. Futures contracts are traded only on specially organized relevant exchanges, facilitating trade between absolutely unknown persons. Trading on specially organised markets, on the other side, reduce the costs of the deal and the effort for finding counterparty. The most common parties to forward contracts are banks, investment companies and non-banking financial institutions, which normally conclude them to meet specific requirements of their clients or for hedging different types of risks. The volumes of trading are not strictly defined, and any quantities are allowed for trade, depending on the specific needs of parties to the contract.

Unlike spot deals, where the assets are traded on immense delivery, the moments of concluding and the execution of the forward agreement (delivery of a specified asset for a price agreed when the deal was concluded) are apart from each other.

The duration of the forward contracts in most cases is up to one year. For transactions, concluded in the main international currencies, this period may be up to two and more years. In some cases, forward contracts have longer duration (5 to 10 years.) Some authors call these contracts "long" forwards. The length of the term of these contracts is directly proportional to risk of insolvency of one of the two contractual parties. Logically, the forward price of such contract is higher, but when its use is justified, it is worth the extra cost.

Forward agreements, by definition, cannot be terminated prior to expiration. It is possible, however, to be concluded the opposite ("off-set") transaction to close out an open position: sale or purchase of the underlying asset with the same maturity date. The net impact of both transactions can be profit or loss.

In view of the existence of risk of non-payment at maturity of forward contract, the seller requires collateral in order to guarantee the performance of the obligation - the so-called "margin deposit." The total amount of the margin deposited is normally established as a percentage of the due amount, and can be in the form of cash or securities. Depending on current market conditions, the amount of margin required may be corrected if found deficient.

Forward transactions are informal contracts. In order to be legally valid and binding, the informal contracts need not be concluded in writing and are not subject to any other specific requirement as to form. In practice, with a view to clarity of contents of the contract, forward contracts are usually concluded in writing.

In the electronic trade, the electronic contract shall be deemed to be concluded upon order placement, payment of the initial margin deposit, covering the purchase or sale of a forward contract, and receipt of confirmation of acceptance of the order.

Since forward contracts are not exchange traded, they are less liquid than other financial instruments, traded on regulated market; they bear higher risk of failure of the seller to deliver at maturity date or buyer to pay the full value of the delivery to the seller.

Nelly Naneva works as CEO of the Financial Institution Freetrade JSC, Sofia, Bulgaria and as Editor of the Online Financial Magazine Markets Weekly. She holds Masters' Degrees in Law from Sofia University St. Kliment Ohridski, Bulgaria and in Banking and FInance from Institute of Financial Services, School of Finance, London, Great Britain.

Source: EzineArticles
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