FORWARD CONTRACT: Definition, Types, and How It Works

forward contract

Forward and futures contracts are derivatives agreements in which two parties agree to acquire or sell a specified asset at a predetermined price at a future date. By locking in the purchase/sale price in advance, buyers and sellers can reduce the risks associated with future price movements. Here we’ll go in-depth about the forward contract and understand what it means for investors. We’ll also compare the futures vs forward contract currency and know when to utilize it.

What Is the Definition of a Forward Contract?

A forward contract is an agreement between a buyer and a seller to lock in a commodity’s current price for future sale. It’s a sort of derivative contract (an agreement between two parties for the future exchange of an asset) utilized by financial institutions’ purchasers and sellers to protect against market price changes. Forward contracts can be beneficial in highly unpredictable markets. They provide both parties with certainty in the exchange of a product at a set price.

A forward contract comes to an end with cash or contract delivery on the agreed-upon settlement date. Unlike other derivatives like futures, which are based on the daily stock exchange, forward contracts do not trade on exchange rates. Hence, they are considered over-the-counter (OTC) deals. Forward contracts are used by buyers to reduce the risk of a commodity’s market value as it increases.

How Does a Forward Contract Work?

There are four essential components to consider with forward contracts. The four elements are as follows:

  • Asset: The underlying asset described in the contract is referred to as the asset.
  • Expiration Date: This is when the agreement is settled, the asset is delivered, and the deliverer is paid, the contract must include an expiration date.
  • Quantity: This is the contract’s size, and it specifies the quantity of the item being purchased and sold in units.
  • Price: You must also provide the price that will be paid on the maturity/expiration date. This includes the currency in which the payment will be made.

On centralized exchanges, forwards are not exchanged. Instead, they are tailored, over-the-counter contracts made between two parties. The contract must be settled by the expiration date. The underlying asset will be delivered by one party, while the other will pay the agreed-upon amount and gain possession of the asset. Instead of providing the physical underlying asset, forwards might be settled in cash at the expiration date.

What is the Purpose of a Forward Contract?

Forward contracts are mostly used to protect against losses. They allow the participants to lock in a future price. This fixed price is especially crucial in businesses where prices are prone to severe volatility. In the oil business, for example, engaging in a forward contract to sell a specified quantity of barrels of oil can be used to hedge against prospective price drops. When making substantial foreign transactions, forwards are also widely utilized to hedge against changes in currency exchange rates.

Forward contracts can also be utilized only for the sake of speculation. Because forwards are formed by two parties and are not available for trade on centralized exchanges, it is less frequent than using futures. A speculator may take a long forward position if they anticipate the future spot price of an asset will be greater than the forward price today. They will earn if the future spot price is higher than the agreed-upon contract price.

Types of Forward Contracts

Investors should be aware of the many types of forward contracts available.

  1. Closed Outright: This is the most common sort of forward. Two parties agree to finish a deal on a specified date for a set price.
  2. Flexible: A flexible forward allows the two parties to resolve the contract before the contract’s deadline. Settlement can take place in a single transaction or over multiple payments.
  3. Long-dated: Most forwards have a short maturity period, such as three months. Long-date forwards can last for several months or even a year.
  4. Non-deliverable: There is no physical exchange of monies with these forwards. Instead, the contract is settled by the two parties exchanging cash, with the amount paid based on the contract price and the market price of the underlying commodity or currency.

The Advantages and Disadvantages of a Forward Contract

Advantages of a Forward Contract

Forward contracts are simple to comprehend, making them an excellent tool for novices. Forwards are commonly used for speculating or hedging since the contract price remains constant regardless of whether the asset price changes. This means the traders can be certain of the price they will be purchasing or selling at.

Forward contracts, as previously stated, provide a great deal of flexibility because dates and amounts can be customized. Even while forward contracts have an agreed-upon expiration date, this does not mean they must be maintained open indefinitely. If you wish to reduce your losses or capture winnings, most forward contracts can be closed early.

Disadvantages of a forward contract

It is critical to understand the risks that both parties face when entering into a forward contract. First, there is no guarantee of product quality because forwards are traded over the counter rather than on an exchange, and asset variation is not regulated. The exchange, on the other hand, would be unaffected if traders chose to settle in cash rather than taking delivery of the asset.

Second, there is the possibility of default. A forward contract’s value improves for one party while becoming a liability for the other when the price fluctuates. This implies that there is some counter-party risk, in which the contract may not be honored notwithstanding the commitment.

Forward Contracts Alternatives

The futures contract is the most simple alternative to the forward contract.

A futures contract, like a forward, allows two parties to agree to undertake a transaction at a specific price on a specific date. It can be used to hedge against fluctuations in commodity prices in the same way that a forward contract can.

Futures are regulated, traded on a public exchange, and standardized by the clearinghouse engaged in the transaction, which is the main distinction. The clearinghouse also helps to ensure that the transaction is completed successfully, lowering the danger of one of the two parties defaulting.

Futures are thus safer, but they are also less adjustable and versatile than forwards.

Forward Contract vs Futures Contract; How do They Differ?

A forward contract is a customizable over-the-counter derivative contract in which two parties agree on the price of a commodity for future sale. Futures are derivative contracts that buyers and sellers use in commodity trading to guarantee the sale of a commodity, but they are settled at the end of each day. Though both are intended to lock in the price of a product, there are a few distinctions.

  1. Forward contracts are adaptable. The parties can choose the commodity, the amount of the commodity to be traded, and the delivery date for forward contracts. Forward contracts are not as standardized as futures contracts.
  2. They occur throughout varying periods of time. Forward contracts are settled at the contract’s agreed-upon termination, which could be months away. Futures contracts are marked-to-market every day and settled day by day until the contract expires.

Futures on commodities are exchanged on exchanges. A futures contract trades on a market exchange, whereas a forward contract does not. Futures contracts have clearinghouses, which ensure that transactions are completed.

Futures are less dangerous. Because the terms are settled on a daily basis, the futures market may have less default risk and credit risk than forward contracts, yet it is not completely risk-free. Forward contracts are lengthier, giving either party greater time to break their contract.

Financial assets (stocks, bonds, currencies, market indexes, and interest rates) and commodities are among the underlying assets for forward and futures contracts (crops, precious metals, oil, and gas-related products).

Example of Forward Contract vs Futures Contracts

Let’s look at a hypothetical example of each of these derivatives to see how they function.

#1. Forward contract

Assume a producer has a large supply of soybeans and is concerned about the commodity’s price dropping in the near future. To mitigate the risk, the farmer strikes a contract with a financial institution to sell three million bushels of soybeans at $6.50 per bushel over the course of six months. The contract will be settled in cash by both parties.

By the time the contract is due for settlement, soybean prices can vary in a number of ways:

  • The pricing is exactly what was agreed upon. The contract has been fulfilled, and neither party owes the other any extra funds.
  • The price is less than what was agreed upon. If the price lowers to $5 per bushel, the settlement will still be completed at the agreed-upon price. This signifies that the producer’s wager to protect against a price reduction pays off.
  • The price is higher than what was originally agreed upon. Even though the producer may have profited from a higher per-barrel price, the contract is settled at the agreed-upon price.

#2. Futures Contract

Oil producers frequently sell the commodity through futures contracts. This allows them to set a price for it and deliver it once the expiration date arrives. But suppose Company A is concerned that demand may slow, affecting the price of oil on the market, and thus its bottom line. The corporation engages in a futures contract to lock in the oil price at $75 per barrel for the next six months, expecting it will fall.

Company A can still settle the contract at the original promised price of $75 per barrel and make a profit of $10 per barrel if demand falls and the price drops to $65 per barrel. However, if demand grows and the price climbs to $85 per barrel, Company A will miss out on the opportunity to profit an additional $10 per barrel from the contract. Keep in mind that if the price stays the same after the six-month period, there is no risk.

What Are the Benefits of Futures Contracts Over Forward Contracts?

Because futures contracts are exchanged on exchanges, unlike forwards, which are negotiated privately between counterparties, their details are made public. Futures have less counterparty risk than forward contracts because they are regulated. These contracts are also standardized, meaning they have predetermined terms and expiration dates. Forwards, on the other hand, are tailored to the parties’ specific requirements.

Is It True That Forward Contracts Are Marked-To-Market?

There is no mark-to-market on forward contracts. This is because they are only settled on the agreed-upon settlement date. In contrast to futures, which are marked-to-market, options are not.

Forward Contracts’ Risks

Many of the world’s largest firms utilize forward contracts to hedge currency and interest rate risks, creating a massive market. However, since the contents of forward contracts are restricted to the buyer and seller—and are not disclosed to the broader public—the size of this market is impossible to assess.

In the worst-case scenario, the forward contracts market’s size and unregulated structure make it vulnerable to a cascade series of defaults. While banks and financial firms can reduce this risk by carefully selecting counterparties, large-scale default is still a possibility.

Another risk associated with forward contracts’ non-standard nature is that they are not marked-to-market like futures and are only resolved on the settlement day. What if the contract’s specified forward rate differs significantly from the spot rate at the time of settlement?

In this instance, the financial institution that originated the forward contract faces a higher risk of default or non-settlement by the client than if the contract was marked to market on a regular basis.

Forward Contract FAQs

What is the limitations of forward contract?

The drawbacks of forward contracts are as follows: it necessitates the tying up of capital. Before settlement, there are no intermediary cash flows. It is vulnerable to default risk.

Is forward contract risky?

Forward contracts primarily help buyers and sellers control the volatility associated with commodities and other financial transactions. Because they are over-the-counter investments, they are riskier for both parties involved.

Are forward contracts legally binding?

A forward contract is a legally binding commitment to deliver goods or the underlying asset on a certain date in the future at a price agreed upon at the time the contract is signed.

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