The 3 Scenarios Of Buying A Forwards Contract
When two parties enter into a forwards contract then irrespective of what the price of the commodity is the buyer is obliged to buy at a predetermined price and the seller is obliged to sell at the predetermined price.
So why do the parties enter into the contract at a particular price. The reason for this is that the buyer may feel that the price of the commodity would go up by the time he decides to purchase it and he thus locks in today’s price to save himself from paying extra at later date.
The seller, on the other hand, thinks that the price of the commodity would go down and thus locks in today’s price to save himself from the fall in price. The party that agrees to buy the asset at some future point is the buyer of the forward’s contract and the party who agrees to sell it at a future date is the seller of the contract.
Since both, the parties who are involved in the transaction have views that are opposing and thus this is why they enter into an agreement which is the forward’s contract.
There are three possible scenarios that can come up with entering into a forwards contract.
The price of the commodity could go higher. In this case, the buyer benefits because he had locked in the price and thus he can buy the gold at a lower price. Thesellerhoweverhas a loss because had he not agreed to sell the commodity at the price he could have made more money when he sold it today. However, he is obliged to sell the commodity at the predetermined price.
The commodity prices go down. Here the buyer is at a loss because he has signed a contract to pay a higher price to the seller. So even if the commodity prices are down it does not matter. The buyer still has to pay a higher price to the seller. This means that the seller ends the transaction in a profit.
The price of the commodity stays the same. When this happens then none of the parties benefit from entering the forward contract. It is just like a normal transaction that happens on any particular day. The buyer pays the gold price and the seller gives the buyer the required quantity of gold.