How Are The Forward Contracts Settled?
The two parties enter into a contract to settle the forward contract at a set date in the future at a set time for a predetermined price. There are two ways in which the parties can settle off the agreement.
Physical settlement of the commodity
The buyer pays the full amount of the purchase of the forward contract to the seller and the commodity then gets delivered to the buyer by the seller. This is called the physical settlement of the asset.
When this happens then there is no actual commodity or asset physical delivery. The buyer, as well as the seller, just exchange the cash difference that gets generated. The cash difference is paid off which could be either from the buyer to the seller or form the seller to the buyer and the transaction is closed.
So the settlement between two parties that enter into a forward contract happens either as a physical settlement or a cash settlement.
The risk that is involved when you enter into a forward contract
There is risk involved when you enter into a forwards contract. This risk is not just associated with the movement of the price.
In theory, it can be easy to say that a buyer can easily find a seller who would agree to enter into a forwards contract for a set price. But this is not so easy when real transactions happen in the real world. The party would have to get in touch with an investment bank and let them know what their intentions are. The investment bank will look around the market for someone who holds just the opposite view to the buyer and then the contract is signed between the two parties. The investment bank acts as a middleman and to let the buyer meet the seller the investment bank charges a hefty fee.
Risk of default
Both the parties enter into a forwards contract at a set date. Butwhentheactual date of the settlement comes and one is in a heavy loss then there are chances that the loss-making party could default on the agreement.
The contract is entered by two parties and there is no regulatory body over them. This increases the risk of default because there is no law involved.
The forward contracts also a very rigid contract. If at some point midway before the forward contract is settled both the parties have a change of view, then the forward’s contract does not let them change the agreement. There is also no option to foreclose the agreement in advance. And this was why the futures contract came into existence.