Forward Contract - Explained
What is a Forward Contract?
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Table of ContentsWhat is a Forward Contract?How Does a Forward Contract Work?Forward Contracts Versus Futures ContractsExample of a Forward ContractFast Facts
What is a Forward Contract?
A forward contract is referred to as a customized contract physically signed between party A and party B, i.e., face to face (or over the counter) in regards to a future transaction of an asset. The contract is used by both parties to establish and agree on the fundamentals such as the price, quantity and delivery date of the asset about to be bought or sold. A long-term position is assumed by the party agreeing to buy the asset in question in the future, while the party agreeing to sell the asset in the future assumes a short-term position. The delivery price is the price agreed upon. This contract although best used for hedging, can also be used for speculation.
How Does a Forward Contract Work?
A forward contract is customizable to contain the commodity to be bought or sold, the amount it is to be sold, and the agreed date it will be delivered, referred to as the delivery date. Commodities such as grains, precious metals, oil or even poultry can be traded and settled with cash or a delivery basis. Forward contracts are regarded as over-the-counter (OTC) instruments because they are not traded on the basis of a centralized exchange. This has made them be easily customizable and gives room for a higher degree of default risk. This has led to a scarcity in the availability of forward and futures contracts to retail investors.
Forward Contracts Versus Futures Contracts
Although an agreement to buy or sell a commodity at a future date at a set price is common to both and forward and futures contracts, slight differences exist between them. Forward contracts are not exchange-traded or defined based on standardized assets. In margin requirements like futures - such that both parties don't exchange additional property securing the party gaining and the whole unrealized gain or loss builds up even while the contract is open, they generally lack partial settlements or "true-ups". Forward contracts are settled at the end of the contract. Futures contracts, on the other hand, are settled on a daily basis.
Example of a Forward Contract
For example, a corn farmer has six million bushels of corn to sell in October. He will obviously want to sell them at a good price, but he may be worried that its market price in October will be lower than the current price at which he is willing to sell. In order to avoid this, he signs a forward contract with his financial institution to sell them at an agreed price of $4.30 in six October, with settlement on a cash basis. By October, it is either no money is owed by any of the parties (spot price = $4.30), the farmer owes the institution (spot price > $4.30), or the institution owes the farmer (spot price < $4.30). Risks with Forward Contracts The use of forward contracts to hedge currency and interest rate risks by many of the world's biggest corporations has created the presence of a huge market for the forward contract. Although, the market size is difficult to ascertain as the contract details are known only to the two parties and unknown to the general public. This means that the contract is highly open to a surge of defaults in the worst-case scenarios. The agreement of settlement only on a specified future date is another risk arising from the non-standardized nature of forward contracts. There might be a wide divergence between the forward rates specified in the contract and the spot rate at the time of settlement.
- A forward contract is a customizable contract physically signed between party A and party B, i.e., face to face in regards to a future transaction of an asset.
- Forward contracts can be customized to contain the price, quantity and delivery date of the asset about to be bought or sold.
- Forward contracts don't trade on the basis of a centralized exchange and are regarded as over-the-counter (OTC) instruments.
- Making use of a forward contract requires the credibility of both parties, i.e., both parties should keep their promises and fulfill the contract on the delivery date.
- Inflexibility is a weakness associated with forward contracts. Once the contract is signed, neither party has much flexibility to change it.