Please provide an introduction to forward contracts


A forward contract is an agreement made directly between 2 parties to buy or sell an asset on a specified date in the future, at the terms decided today.
Forwards are widely used in commodities, foreign exchange, equity and interest rate markets.

Let's take an example. 
What's the basic difference between cash market and forwards?

Assume, on Dec 1st, 2016 you want to purchase gold from a goldsmith. On Dec 1st, 2016 the market price for gold is Rs.28,150 for 10 grams and the goldsmith sells you the gold at this market price. You pay him Rs.28,150 and you take the 10 gms of gold. This is a cash market transaction.

Now suppose, you do not want to buy gold on Dec 1st, 2016 but only a month later, i.e. Jan 1st, 2017.
The goldsmith quotes you Rs.28.150 for 10 gms of gold, you agree to the forward price for 10 gms of gold and go away.

Here, you have bought forward or you are long forward in Gold, whereas the goldsmith has sold forward or is short forward in gold.
There is no exchange of gold and money at the current time. After a month, you pay the goldsmith Rs.28,150 and you collect your 10 gms of gold.

This is a forward, where both the parties are obliged to go through the contract irrespective of the value of the underlying asset(here Gold) at the point of delivery.

Essential features of a forward are:

- it is a bilateral contract - a contract between two parties.

- all terms of the contract like price, quantity of underlying, delivery terms like place, settlement procedure etc are fixed on the day of entering the contract.

Forwards are bilateral over-the-counter(OTC) transactions where are terms of the contract are negotiated between two parties to the contract. Alteration to the contract is possible if both parties agree to it.

Corporations, traders and investing institutions use extensive OTC transactions to meet their specific requirements.

The essential idea of entering a forward contract is to fix the price and thereby avoid price risk. Thus, by entering into forwards, one is assured of the price at which one can buy/sell an underlying asset.

In the above ex,
If on Jan 1st, 2017 gold trades at Rs.28,250 in the cash market, then the futures market becomes favorable to you because you can purchase gold at Rs.28,150 under the contract 
and you can sell it at Rs.28,250 in the cash market with a net profit of Rs.100 per 10 gms. 
Similarly, if the spot price is trading at Rs.28,100, then you incur a loss of Rs.50 per 10 gms.