A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.
Key Takeaways
A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specified price on a future date.
Forward contracts can be tailored to a specific commodity, amount, and delivery date.
Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.
For example, forward contracts can help producers and users of agricultural products hedge against a change in the price of an underlying asset or commodity.
Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk compared to contracts that are marked-to-market regularly.
Unlike standard futures contracts, a forward contract can be customized to a commodity, amount, and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.
Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.
Because of their potential for default risk and lack of a centralized clearinghouse, forward contracts are not as easily available to retail investors as futures contracts.
Both forward and futures contracts involve the agreement to buy or sell a commodity at a set price in the future. But there are slight differences between the two. While a forward contract does not trade on an exchange, a futures contract does.
Settlement for the forward contract takes place at the end of the contract, while the futures contract settles on a daily basis. Most importantly, futures contracts exist as standardized contracts that are not customized between counterparties.
Example of a Forward Contract
Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.
In six months, the spot price of corn has three possibilities:
It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.
Risks of Forward Contracts
The market for forward contracts is huge since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller—and are not known to the general public—the size of this market is difficult to estimate.
The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.
Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?
In this case, the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.
One of the most common forward contracts involves the sale of a commodity. Suppose a cattle farmer wishes to sell 100,000 cattle in six months. He wants to lock in the price now, so he enters into a forward contract with his bank to sell 100,000 cattle in six months for $10 million.
Risks involved while trading in Forwards Include, liquidity risk, default risk, regulatory risk and lack of flexibility. The main areas of differences between Forwards and Futures lie in their contract terms, their default risk, regulation, initial margin and settlement.
Forward contracts enable you to reserve a forward price for buying or selling currencies on a specific date in the future. The price you lock in is determined on the day you agree the amount and settlement date for the forward contract.
Forward contracts can be used for speculation, where risk is taken with the intention of making a profit. However, ironically, they can also be used for hedging purposes. This is where they allow risk to be avoided.
For example, a company proposes to borrow USD 10 million after three months for a tenure of six months. It agrees to pay the lender 1 percent over the six-month Libor prevailing on the date of drawdown of the loan.
Forward contract is used for hedging the foreign exchange risk for future settlement. For example, An importer or exporter having FX contract limit may lock in current exchange rate by entering into forward contract with the bank to avoid adverse rate movement.
With a forex forward contract, you can lock in a currency rate for a future transaction. This can protect you from currency fluctuations if the exchange rate moves against you. A forex forward contract can be used to hedge against currency fluctuations.
As we have discussed above, the Forwards contract there is no regulatory authority that governs the agreement. It is executed by the mutual consent of both the parties involved in this contract. As there is no regulatory authority, it increases the risk ability of either of the parties defaulting.
A forward contract is a promise to buy or sell an asset at a future date at a price agreed to at the contract's initiation. The forward contract has a linear payoff function, with both upside and downside risk.
Forward contracts are mainly used to hedge against potential losses. They enable the participants to lock in a price in the future. This guaranteed price can be very important, especially in industries that commonly experience significant volatility in prices.
Advantages and Disadvantages of Forward Exchange Contracts
The certainty provided by the contract helps a company project cash flow and other aspects of business planning. The disadvantage of the forward contract is that neither party can profit from a significant currency exchange rate shift in their favor.
Record a forward contract on the contract date on the balance sheet from the seller's perspective. On the liability side of the equation, you would credit the Asset Obligation for the spot rate. Then, on the asset side of the equation, you would debit the Asset Receivable for the forward rate.
The counterparty risk on a forward currency contract is the risk that the counterparty fails to meet their obligations. The counterparty on a forward currency contract is generally a large bank with international operations.
Protection Against Market Volatility: Forward contracts allow corporations to protect against fluctuations in commodity prices, interest rates, and foreign exchange rates. They serve to create some form of price stability and predictability, essential in financial planning and budgeting.
Forward Contracts can broadly be classified as 'Fixed Date Forward Contracts' and 'Option Forward Contracts'. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date.
A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.
Forward contracts involve two parties agreeing to buy or sell an asset at a future date and a predetermined price. Upon contract maturity, the buyer purchases the asset at the agreed price, regardless of the market price at that time.
The business meets with the supplier, and agrees to pay USD $500,000 in 3 months from now. The current GBP / USD exchange rate at the time of the deal is GBP £1.00 = USD $1.32. ABC Factory therefore expects to pay GBP £378,788 for the equipment.
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