What are forward contracts? Definition and uses
A forward contract (sometimes known as a forward purchase agreement) is a legal agreement between two parties concerning the future trade of an asset — at a specified price, for a specified volume, and on a specified date.
This article will explain what forward contracts are and look at an example scenario.
As they’re a type of derivative, we’ll also compare futures vs forwards.
What is a forward contract?
A forward contract is a legal agreement where two parties commit to trading a particular asset at a specified point in the future (for a set price and quantity).
The asset could be stocks, currencies, property, or commodities such as oil, metals, and foodstuffs.
Markets can be volatile, with asset prices rising and falling unpredictably as conditions change. If an asset price falls, this might be great for buyers but a disaster for sellers and producers. If it rises, the opposite may be true.
Different parties will have their own motives for entering into a forward contract.
Primarily, they’re a tool for hedging risk. By locking in specific terms for future trade, sellers and buyers gain certainty about the future.
The seller in a forward contract will typically take a ‘short’ position.
They believe the price of the asset they are selling might decrease, so it’s therefore beneficial to lock in more favorable terms.
The buyer, meanwhile, will take a ‘long’ position i.e. they believe the price of the asset they’re buying might increase.
Thus, they want to lock into the cheaper price ASAP.
In short, forward contracts are a valuable tool to help parties manage market volatility and enable more predictable long-term business planning.
How do forward contracts work?
Firstly, the contract must be negotiated.
The two parties must agree on a price, date, and volume that they’re both happy with.
After signing the contract, the asset price may change, either increasing or decreasing, according to socio-economic, geopolitical, or environmental factors.
However, none of this affects the agreed-upon transaction in the forward contract.
When the expiration date is reached, the transaction must be conducted and concluded according to the agreed-upon terms.
The volume specified must be traded at the price and on the date listed.
This obligation must be met.
Forward vs. futures: The difference between forward contracts and futures contracts
Both forward and futures contracts are types of derivatives.
That means they’re financial instruments developed, initially at least, to help hedge risks (although, increasingly, derivatives are also starting to be used as a high-risk, high-reward speculation tool by investors).
Forwards and futures involve an agreement to trade an asset at a fixed price in the future.
They both lock in a future price to help the parties to the contract hedge against the risk of price fluctuations.
However, there are crucial differences between forward and futures contracts.
The key points are summarized below.
|Forward contract||Future contract|
|Format||Customizable to the needs of the two parties (e.g. the price, date, and volume are free to be negotiated).||Highly standardized and transparent terms.|
|Trading||Not traded.||Traded on the exchange.|
|Regulation||Self-regulated.||Regulated by stock exchanges.|
|Settlement||Settled between the two parties upon expiration.||More liquid and can be traded daily. Often closed out prior to maturity.|
Forward contracts are primarily used when two parties (a seller and buyer) wish to hedge the risks of market volatility.
They allow them to create a contract that meets their respective needs for the trade.
Futures contracts are more commonly used for speculation e.g. to directly profit from market fluctuations.
What’s an example of a forward contract?
Imagine you’re a potato farmer dependent on the profit you make from your annual harvest.
You’re nervous that potato prices will fall in the coming months.
Thus, you’d like to lock in the current market price.
Now, imagine that your biggest customer, a crisp manufacturer, is nervous that prices might actually rise.
Both you and your customer face a market risk.
To hedge that risk, you might agree to enter a forward contract specifying that you supply 100 tones of potatoes in six months at an agreed price (perhaps similar to the current market price).
Thus, both parties are protected from the worst-case scenarios of rising and falling prices.
This can provide a safer and more stable basis on which to plan for the future.
What are the risks of a forward contract?
While forward contracts are a tool to help hedge against risk, they still entail several risks in their own right.
- The other party may default, causing you costs and inconvenience.
- Market fluctuations may ultimately disadvantage you.
- Tying up your investment capacity for the future in this way can carry an opportunity cost.
- Regulatory, legal, or political changes may impact an agreed (but yet to be fulfilled) forward contract.
- Forward contracts aren’t regulated, which can put them at a higher risk of defaulting.
- As unregulated, private arrangements, forward contracts are less liquid than futures contracts (which can be easily exchanged). Once signed, you’re stuck with them!
Forward contracts are widely used and play a significant role in global trade. However, their terms aren’t made public as they’re private agreements.
This makes it hard to estimate how often things go wrong with them.
Forward contracts shift the emphasis of risk. They do not eliminate it.
For example, parties to a forward contract must feel confident in each other’s ability to deliver on their obligations.
Such risks need to be carefully assessed as part of your decision-making.
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