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Forward contract

Category — Derivatives
By Nikita Bundzen Head of North America Fixed Income Department
Updated January 17, 2025

What is a Forward Contract?

A forward contract, often shortened to just forward, is an agreement between two parties to buy or sell an asset at a specified price at a specific date in the future. This type of agreement allows the buyer to lock in the agreed-upon price of the underlying asset, mitigating potential volatility in the spot market.

Since forward contracts refer to the underlying asset that will be delivered on the specified date, they are considered a type of derivative. Unlike futures contracts, forward contracts are privately negotiated and are not traded on a futures exchange. Therefore, they carry counterparty risk and default risk because they are not standardized and are not subject to the margin requirements typically enforced in the futures market.

The party who buys a forward contract is taking a long position, anticipating that the underlying asset's price will increase. Conversely, the party selling a forward contract takes a short position, benefiting if the asset's price decreases.

/></p> <h2>Forward Contract Explained</h2> <p>When a party buys a forward contract, they are taking a long position. Conversely, the party selling the forward contract is taking a short position. If the price of the underlying asset increases, the long position benefits. If the underlying asset's price decreases, the short position benefits.</p> <p>Unlike futures contracts, forward contracts are privately negotiated and not traded on a futures exchange. This means they do not have standardized terms and are tailored to the specific needs of the parties involved. Forward contracts can involve a variety of assets, including foreign currency, precious metals, and commodities. They also carry counterparty risk, as there is a chance that one party may default on the agreement.</p> <p>Forward contracts do not require margin and can be customized for the specific needs of the involved parties. The agreed-upon price in a forward contract is known as the forward price, and the contract typically specifies the trade date, delivery date, and maturity date. The contract price is set to reflect the future spot price expected at the time of delivery.</p> <p>The Federal Reserve Bank may use forward rate agreements to manage interest rates and exchange rates. Forward contracts can be cash-settled if the parties prefer not to deliver the actual asset. This involves settling the difference between the contracted rate and the spot price at the time of settlement.</p> <h2><strong>Сomponents</strong></h2> <ol> <li> <p><strong>Asset</strong>. This is the underlying asset that is specified in the contract. It could be a physical commodity, foreign currency, or other financial instrument.</p> </li> <li> <p><strong>Expiration Date</strong>. The contract will need an end date when the agreement is settled, and the asset is delivered. The deliverer is paid on the specified date, also known as the delivery date or maturity date.</p> </li> <li> <p><strong>Quantity</strong>. This is the size of the contract, and it specifies the amount in units of the asset being bought or sold. The quantity ensures clarity on the specific volume of the underlying asset involved in the forward contract.</p> </li> <li> <p><strong>Price</strong>. The price that will be paid on the expiration date must also be specified. This agreed-upon price is often referred to as the forward price or the contracted rate. It also includes the currency in which the payment will be rendered.</p> </li> </ol> <h2>Characteristics</h2> <ol> <li> <p><strong>Private And Binding Agreements</strong>. Forward contracts are private and binding forward trade agreements between the buyer and seller. These agreements specify the terms for buying or selling the underlying asset at a future date for a specified price.</p> </li> <li> <p><strong>Traded Over-The-Counter</strong>. They cannot be traded on a centralized exchange like futures contracts but are instead traded as over-the-counter instruments. This means they are not standardized and are tailored to the needs of the parties involved.</p> </li> <li> <p><strong>Non-Standardized</strong>. Forward contracts are non-standardized, meaning they can be customized at any time throughout the trading duration. The terms, such as the expiration date, quantity, and price, can be adjusted to fit the specific requirements of the transaction.</p> </li> <li> <p><strong>Common In Certain Markets</strong>. They are typically used within markets where spot prices are more common. Examples include the commodities market, where popular raw materials such as oil, gas, corn, sugar, silver, and gold are traded. Forward trading has also expanded to include currency forward contracts, indices, and treasuries.</p> </li> <li> <p><strong>Traded Through Spread Betting Or CFDs</strong>. Forward contracts can be traded through financial instruments like spread betting or Contracts for Difference (CFDs). These instruments allow investors to speculate on the price movements of the underlying asset without actually owning it.</p> </li> </ol> <h2>Futures VS. Forwards</h2> <ol> <li> <p><strong>Trading Venue</strong>. Futures are traded on a futures exchange. Forwards are privately negotiated over-the-counter.</p> </li> <li> <p><strong>Standardization</strong>. Futures are standardized with exchange-specified contract units, expiration dates, tick sizes, and notional values. Forwards are customized, allowing terms to be tailored to the specific needs of the parties involved.</p> </li> <li> <p><strong>Counterparty Risk</strong>. Futures have no counterparty risk, as payment is guaranteed by the exchange clearing house. Forwards are subject to credit default risk since they are privately negotiated and rely entirely on the counterparty for payment.</p> </li> <li> <p><strong>Transferability</strong>. Futures are actively traded on the futures market, making them transferrable. Forwards are non-transferrable, as they are custom agreements between specific parties.</p> </li> <li> <p><strong>Regulation</strong>. Futures are regulated by financial authorities, ensuring transparency and oversight. Forwards are not regulated, due to their private and customized nature.</p> </li> </ol> <h2><strong>What are Forward Contracts Used For?</strong></h2> <p>Forward contracts are primarily used for hedging purposes. They allow participants to lock in a future price, which helps protect against price volatility. This is especially important in industries like oil, where price swings can significantly impact financial outcomes. By entering into a forward contract, a company can secure a set price for selling a specific quantity of oil, mitigating the risk of price drops.</p> <p>Another common use is hedging against currency exchange rate fluctuations. When making large international purchases, companies can use forward contracts to fix the exchange rate, protecting against adverse currency movements.</p> <p>Forward contracts can also be utilized for speculative purposes. Although less common than futures, speculators might enter a long forward position if they anticipate the future spot price will be higher than the current forward price. If their prediction is correct, and the future spot price exceeds the contract price, they can achieve a profit.</p> <h2>Example</h2> <p>Consider an agricultural supplier looking to sell 1000 barrels of white sugar in six months for £10,000. Concerned about potential losses due to declining weather conditions affecting supply and demand, the supplier enters into a cash settlement forward contract with an international buyer. They agree to a specific price of £10,000, based on the spot exchange rate at the time of the agreement.</p> <p>After six months, the spot price of sugar can change in three ways. If the spot price remains the same at £10,000, the contract is settled without any additional payment. If the spot price is higher than the contract price, the supplier will owe the buyer the difference between the spot price and the contracted forward rate. Conversely, if the spot price is lower than the contract price, the buyer will owe the supplier the difference. This forward contract helps the supplier hedge against potential losses due to fluctuating future prices in the forward market.</p> </div> <div class=

FAQ

  • Why would you buy a forward contract?

    You would buy a forward contract to lock in a specific price for an underlying asset, protecting against future price volatility and potential losses. This helps in securing a favorable rate for future transactions.

  • Is a forward contract a gain or loss?

    A forward contract can result in a gain or loss depending on the underlying price at the contract's expiration. If the future price exceeds the agreed-upon contract price, the buyer gains. If it falls below, the buyer incurs a loss.

  • Who uses forward contracts?

    Forward contracts are used by retail investors, businesses, and institutions to hedge against price fluctuations. They are also utilized by speculators aiming to profit from expected changes in future prices. Both parties involved, the buyer and the other party (seller), benefit from the contract's terms to manage financial risk.

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