A forward contract is a contract between two parties who agree to buy or sell an underlying asset at a specific price sometimes in the future. These type of contracts are often used by multinational corporations to hedge against risks or speculate on the underlying asset. Keep in mind that forward contracts are not the same as futures contracts, particularly due to the lack of centralized trading. However, there are many similarities, discussed below.
Types of Underlying Assets
As mentioned, a forward contract is between who parties to agree to buy or sell an underlying asset in the future. The actual exchange of cash or assets take places at a future time but the price is determined upon contract agreement. These underlying assets typically fall into two main categories: financial & commodities.
Financial – Financial forward contracts involve the trading of financial instruments such as currencies, interest rates, shares and other securities. The most common financial forwards are currencies and interest rates.
Commodities – Commodities include natural gas, silver, gold, copper, oil, electricity, wheat, sugar, etc. The commodity market is less centralized than the financial market.
One unique aspect of commodity forward contracts is that they’re customizable and offer flexibility on the commodity type, delivery date and amount. For example, a farmer can sell their crops before the seeds are planted, if he believes that prices would decline in the future. Commodity forwards can be settled in cash or through the actual delivery of the commodity.
Purchasing a Forward Contract
One important thing to remember about forward contracts is that, they do not trade on a centralized exchange but rather over-the-counter (OTC). Due to their over the counter nature and lack of a centralized clearinghouse, these contracts are highly customizable.
The party who buys the forward contract enters a long position where they believe the price of the underlying asset will increase. Alternatively, the party who sells the forward contract enters a short position with the belief that the underlying asset will decrease in price.
Elements of Consideration
Forward contracts have four unique elements of consideration:
- Asset – A forward contract is based on an underlying asset that the two parties agree to do business around. The underlying asset could be a financial instrument such as locking in the price of a currency or a commodity such as a farmer agreed to sell his wheat at a specific price.
- Expiration Date – One important element of the contract is the start and the expiry date. At what date is the contracted deemed settled and if applicable where will the delivery of goods happen?
- Quantity – Quantity refers to the amount of units of the underlying asset agreed to in the contract.
- Price – The most important consideration is price. It refers to the price that the parties have agreed to that will be paid upon settlement/maturity date. Information about the currency that the payment will be processed is included as well.
Example of Transaction
Jim is planning to grow 500 bushels of wheat this year with the harvest happening in 6 months. He believes that the price of wheat will fall in the next 6 months and is looking to lock in the price now. He negotiates a forward contract today that will obligate him to sell 500 bushels of wheat to Dempster’s Bread Company at the time of harvest.
Jim locks in the price of the wheat now and thus eliminated the risk of the falling wheat prices. Upon maturity, Jim will have to deliver 500 bushels of wheat to Dempster’s Bread Company.
Forwards vs Futures
Investors should be aware that forward contracts are not the same as future contracts. Although both investment allow you to buy or sell an asset a specific time at a given price, it’s important to note that forward contracts do not trade on a standardized exchange but rather over the counter. The contracts are private agreements with terms agreed between the corresponding parties.
In regards to settlement, future contracts settle everyday, making them highly liquid in comparison to forward contracts that settle upon maturity. The parties to a forward contract bear more risk considering that there is no clearinghouse that guarantees performance and completion of the contract. If a party to a forward contract were to default, they may be liable to lawsuits by the other party.
Valuing Forward Contracts
The value of a forward contract is linked to the underlying asset. Referring to our example above, if Dempster’s Bread Company is required to pay $2000 for 500 bushels of wheat but the market price drops to $1400 for 500 bushels of wheat, the contract would be worth $600 to the seller as they would get $600 more for their goods. Forward contracts are a zero-sum game, meaning there are no two winners.
The bottom line is that forward contracts are widely used by investment professionals to hedge and speculate. Those who purchase forward contracts to hedge are not seeking to generate a profit but rather minimize their risks. Speculators on the either hand are placing bets on the direction of the underlying asset. They’re unlikely to take possession of the underlying asset. The majority of forward contracts are used by hedgers rather than speculators.
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