Understanding Forward Contracts in Commodities
It is quite normal to use the term forward contracts and futures contracts interchangeably. Fundamentally, forwards and futures are the same as they both entail a commitment to a transaction at a future date at an agreed price. On the date of the expiry of the contract, if the Commodity Price is higher than the contracted price then the buyer benefits. On the other hand, if on the date of expiry of the contract the Commodity Price is lower than the contracted price then the seller benefits. In that sense, both the forward and futures are the same.
But forward contract and futures contracts are also different in 3 distinct ways. Firstly, futures are standard contracts where the lot sizes and the strike prices are pre-defined. This makes the contracts easily tradable. Forwards, on the other hand, are customised contracts between two parties. Secondly, forwards have counterparty risk since the default by one party can put the entire contract in peril. On the other hand listed futures carry a counter-guarantee by the exchange which eliminates the counter-party risk as the clearing corporation acts as the counter party to each transaction. Lastly, forwards are not traded on any exchange. A classic example is the Rupee Forward Contract, which is an Over-The Counter (OTC) contract between two banks. Futures are contracts that are defined and traded on a recognized stock exchange.
Forwards Markets versus spot market contracts..
Most Commodity Markets in India offer trading in forward contracts. To understand forward market contracts, one needs to understand spot contracts a little more closely. In a spot market contract the payment and the delivery of the commodity is instantaneous. Of course, you cannot deliver 10 tonnes of cotton instantly so that spot contract will be executed using an audited Warehouse Receipt (WR) and the delivery will happen subsequently.
On the other hand, forward contracts entail payment and delivery at a future data, but the price and the quantity is decided today. We need to understand this point in contradistinction to a futures contract. A forward contract can only be for delivery of a particular commodity. There is no scope for speculation and trading in case of forward contracts. However, in case of futures, any trader can take a view on the price movement of a particular commodity and buy or sell the commodity futures accordingly. It is for this reason that privately designed forward contracts is extremely popular among the large corporates who look to hedge their commodity risk.
A case study of the Dollar Forwards Market..
One of the most popular examples of a forward market in India is the Dollar Forward Market. In a dollar-forward contract; importers, exporters and foreign currency borrowers hedge their risk. An importer and foreign currency borrower having dollar payables need to hedge against a strengthening of the dollar. On the other hand, an exporter needs to hedge against the weakening of the dollar. While Currency futures are available on the NSE and the BSE to hedge currency risk, the preferred mode for hedging dollar risk is still the dollar forward market. The reasons are two-fold. First, hedging requirements are very unique to the players and hence forward contract matching is much simpler. Secondly, the major participants in the Dollar Forward markets are generally the commercial banks and other financial institutions. Hence the scope for counter-party risk is almost nil in these cases. This is one of the most robust cases of forward trading in India.
Forward markets in the aftermath of the NSEL Default..
In the light of the Rs.5600 crore payment default by the National Spot Exchange Ltd. (NSEL) in July 2013, forward contracts were introduced in select commodities in September 2014 to reduce the speculation and volatility in the commodity markets. However, the forward contracts on the exchange did not really take off and in the first 6 months after the launch the total volumes were less than Rs.6000 crore. There were 3 basic reasons why the exchange sponsored forward contracts did not really take off.
Firstly, after the experience of the NSEL default, most traders and hedgers were wary of trading commodities for delivery. Secondly, the forward contracts did not carry the exchange counter guarantee and that did not go down well with the traders who were not sure whether the counterparty will honour their part of the contract. Thirdly, most brokers felt that the current margin collected on forwards at around 10% was grossly inadequate. In the event of default of the seller, the buyer will be paid 90% of the margin immediately. But then that hardly takes care of the risk of the buyer in a volatile scenario. As a result brokers have not been too keen to push this product to their customers at this point of time.
Challenges in forward market trading..
The biggest challenge for the organized development of the forward market is lack of price discovery. When contracts are customised in quantum and specifications, it is very difficult to bring about price discovery. This is something futures markets are more adept at doing. Then, of course, there is the major issue of counterparty risk which remains a major challenge to the development of forward markets. Lastly, for a long time the forward market has had serious entry barriers. Take the case of the Dollar Forward market. It is still dominated by a handful of banks and large institutions. The need for economies of scale in forward markets makes it almost impossible for small and mid-sized investors to participate meaningfully in the forward markets. That will be the big unfinished agenda for forward markets.