Explanation of Forward Contract with a simple example

Forward Contract Example

Old MacDonald had a farm, and on that farm, he grew corn a lot of corn. This year, he expects to produce 500 bushels of corn that he can sell at the price-per-bushel that’s available at harvest time or he can lock in a price now.

The Crunchy Breakfast Cereal Company needs plenty of corn to manufacture their cornflakes. They send a representative around to Old MacDonald’s farm and offer him a fixed price to be paid upon delivery of 500 bushels of corn at harvest.

With the forward contract, Old MacDonald will receive the delivery price if he can deliver 500 bushels of corn by a specific date. Based upon the expected delivery price, if he’s able to produce the 500 bushels of corn, he can plan this year’s farm revenues and next year’s expenses.

Because Crunchy Breakfast Cereal Company has a forward contract, they can control variable costs (such as the cost of corn) to make their breakfast cereal. Knowing the cost of corn in advance enables them to keep prices steady for the consumer. They risk overpaying Old MacDonald for his corn, but it’s a risk they’re willing to take to hold costs steady and retain market share for their cornflakes.

Example2

Forward contracts were first used by farmers. Let’s understand how a forward contract works with the help of an example of a rice farmer Mr Iyer who is based out of Madurai. Now, cultivation of crops is not an easy job. A farmer needs to plough the fields, sow the seeds, use fertilisers, ensure adequate irrigation etc. Also, he ends up investing a substantial amount of time, energy and resources. But the farmer earns money or returns on his produce only after selling the rice. His entire income is dependent on the produce.

So, let’s assume that currently rice is being sold at 20 per kg. If the price of the rice goes down, he will make losses. And if the price goes up, he stands to gain.

Hence, Mr Iyer would like to eradicate this uncertainty. So, he enters into an agreement with Mr. Raj, who is a wholesaler in Kolkata. The agreement states that Mr Raj will buy 500 kgs of rice at the price of 20 per kg, two months from now from Mr Iyer. This quantity of rice will be delivered to Mr Raj’s warehouse through trucks and the cost of transportation will be borne by Mr. Raj.

It means, in this scenario, Mr Iyer is the seller and Mr Raj is the buyer of this forward contract. The predetermined quantity of rice to be sold is 500 kgs and the price at which the rice will be sold is 20 per kg. Hence, the price of forward contract is 10,000 (500 * 20), which derives its value from the underlying rice.

The contract will be fulfilled on a future date two months from now. This is when the rice will be delivered to Mr Raj’s warehouse and Mr Iyer will receive  10,000. As this a customisable derivative contract terms such as delivering of rice to the warehouse and footing the transport costs can be incorporated into the contract. Also, both the parties in this transaction must agree on these terms.