PROS AND CONS OF FORWARD CONTRACTS
Pros of Forward Contracts:
To fight the volatility in the exchange rate market, forward contracts help to decide upon a specific rate of exchange for up to 2 years. Hence, even if the rate fluctuates severely, increasing the volatility in the market, parties involved in the forward contract can still develop a clear budget because of the fixed rate of exchange decided while entering into the contract. It provides a sense of security as even the minute changes in the exchange rate can make a significant difference in transactions. For instance, referring to long-term overseas contracts, or in the case of major orders placed from an overseas supplier, forward contracts give the party an option to manage those costs within a definite budget.
Forward contracts are not standardised due to which almost every contract has different and varied terms which suit the parties involved. This gives the parties an option to form a contract on the conditions which they think would benefit them the most in the current as well as the future time.
In today's time, global trade is inevitable. Some companies outsource their services in such a way that a company based in India might manufacture in the home country but supply its products to U.S. citizens who pay in dollars, which creates a risk for the company due to fluctuations in the exchange rate market. Therefore, in order to hedge against this risk, the companies use a forward contract to predetermine the price at which the product will be sold to its customers.
Other derivative contracts such as call and put options of different kinds i.e. American and European, require a premium to be paid while entering into the contract. Whereas, forward contracts do not involve any such initial cost to enter into a contract.
Given that forward contracts are not regulated by any regulatory authority, they are not as expensive as other contracts and are fairly easier to maintain and enter into.
Cons of Forward Contracts:
Forward contracts are not always the best way to hedge against the risk due to fluctuations in the exchange rate market. For instance, if the value of the foreign currency goes down, it would be advantageous for the firm but in the case of forward contracts, the firm would stay at a lower lock-in price which could affect its revenues in case there is a significant difference. Now, this also depends on the attitude of the business, a risk-lover person should not go for a forward contract given that there are other and better ways to hedge against the risk such as tracking the market and taking decisions accordingly.
There are certain risks related to forward contracts, amongst which one of the most common and dangerous risks is, risk of default by either of the parties. For example, if one of the parties disagrees to honour the contract, the other party could suffer huge losses and in the case of forward contracts, getting justice would be tougher as these are over-the-counter contracts.
Another problem that comes with forward contracts is an adverse selection and moral hazard which makes it necessary to check the other party i.e. to investigate its current as well as its past status in order to minimise the default risk. These investigations are not only expensive in terms of money but are also time-consuming.
When parties enter into a forward contract where the underlying asset is a physical product, the characteristics of the product might change over time and may vary from the expectation of the buyer. Consequently, making the contract unfavourable for the buyer. This is usually the case with consumable items such as oranges, grains et cetera.
As forward contracts are customised according to the needs of the parties involved in the contract, it shows low liquidity in the market because it would be tough to find another party with the same set of requirements as to enter into the same contract and even if a party is willing, it may not get a high price as there is almost a demand of zero to none for already customised contracts.
In the case of forward contracts, the cash flow has to happen in the future but it requires keeping some capital aside as to not default on the day of the completion of the contract.