What is Forward Contract
Forward contracts are an agreement or contract to buy or sell an asset at a specific price for a specific quantity on a specific future date.
What happens on the date of settlement
Forward contracts settlement can be done in either of these two ways
1. Actual Delivery/Physical Delivery of the Asset
In actual or physical delivery of the asset, the contract is executed as it is. On the date of delivery, the asset (say sugar) is delivered and the payment as agreed upon.
2. Pay the difference
In pay the difference, the price of the asset, as agreed upon in the contract, is compared with the current price of the asset in the market. Based on the difference in the two prices, whosoever is in profit is in profit is compensated by the party.
Let us understand this whole working of a forward contract with a practical example.
Imagine you are a farmer growing wheat on the your farm. Now, there is a fair probability that by the time your crop i ready to be sold (say 3 months from today) the price might go down from its current rate of Rs 50 kg. As a farmer, you do not want that . You cannot or do not wish to take the risk of price uncertainty in the market. You are afraid that you might have to sell your wheat at a lower price as you predict that the price is going to fall.