When two people agree to buy or sell an asset at a certain future date for a price they agree on today, this is called a forward contract. Forward contracts are used in trading and banking.
What is Forward Contract?
A forward contract is an understanding between two parties that they will buy or sell an asset at a certain price on a certain date in the future. In basic terms, it’s a personalized agreement that holds a price for a future deal. This can help both buyers and sellers who want to protect themselves from price changes or bet on how prices will move in the future.
A farmer might sign a forward contract to sell their crops at a set price, for example, to protect themselves from price drops. A company could buy a forward contract to make sure it has a steady supply of raw materials at a given price.
How do Forward Contracts Work?
When two people sign a forward contract, they agree to sell a certain asset at a certain price on a certain date in the future. Both sides negotiate and agree on the terms of the contract, which include the asset, the amount, the price, and the date of delivery. After the contract is signed, both sides are legally bound to do what they agreed to do.
If the asset’s market price goes up above the agreed-upon price, the buyer wins because they can buy the asset for less than the current market rate. If, on the other hand, the market price drops below the agreed-upon price, the seller wins because they can sell the item for more than the current market rate. This system lets both sides control risk and maybe even make money from changes in prices.
What are Forward Contracts Used For?
Forward contracts are used for many things, but their main use is to control risk and bet on how prices will move in the future. They are very famous in markets for commodities where prices can change a lot, like agriculture, energy, and metals. Farmers, for example, can use forward contracts to lock in a price for their goods and protect themselves from price drops that might happen.
In the same way, businesses can use forward contracts to make sure they have enough raw materials at a price they know, which lowers the risk of price increases. Investors can also use forward contracts to guess how prices will change in the future and possibly make money if prices go up or down.
But it’s important to remember that forward contracts can also be very risky, since both sides could lose a lot if the market price goes against them.
Example of a Forward Contract
Let’s say you’re a tea seller. You’re worried about how the price of tea changes around the world. To protect yourself from this risk, you make a deal with a buyer in the UK to buy something ahead of time.
The deal says that you will sell the buyer a certain amount of tea at a set price at a certain time in the future, say three months from now. With this, you’ve set a price for your tea and won’t lose money if the price of tea drops on the foreign market.
You’ll make money from the contract because you decided to sell at a higher price than the market rate. This is especially true if the price of tea goes up in the future. If the price goes down, on the other hand, you’ll be glad you locked in the higher price.
Difference Between Forward and Future Contract
| Feature | Forward Contract | Future Contract |
|---|---|---|
| Standardized | Non-standardized (customizable) | Standardized (traded on exchanges) |
| Counterparties | Bilateral (between two parties) | Multilateral (cleared through an exchange) |
| Settlement | Physical delivery or cash settlement | Cash settlement |
| Default Risk | Higher (counterparty risk) | Lower (cleared by an exchange) |
| Flexibility | More flexible terms | Less flexible terms (subject to exchange rules) |
| Trading | Over-the-counter (OTC) | On organized exchanges |
| Margin Requirements | Usually not required | Required (to cover potential losses) |
| Examples | Foreign exchange swaps, interest rate swaps, commodity contracts | Stock index futures, currency futures, interest rate futures |
Pros and Cons of a Forward Contract
| Pros | Cons |
|---|---|
| Customization: Tailored to specific needs. | Counterparty Risk: Risk of default by the other party. |
| Flexibility: Can be structured to meet various requirements. | Lack of Liquidity: May be difficult to sell before maturity. |
| Reduced Price Volatility: Can help hedge against price fluctuations. | Credit Risk: Counterparty’s creditworthiness is a concern. |
| Potential Profit: Can generate profits if the underlying asset’s price moves in your favor. | Complexity: Can be complex to understand and manage. |
| Risk Management: Effective tool for managing risks associated with price fluctuations. | Cost: May involve transaction costs and fees. |
What Is a Forward Hedge?
A forward hedge is a way to protect yourself from losing money because of changes in future prices. Signing a forward contract to buy or sell an object at a set price on a certain date is what it means. This helps to lock in a price, which lowers the risk of prices going down.
One example of a forward contract is when a company agrees to buy a good at today’s price even though it thinks the price of that good will go up in the future. For this reason, the business will have a set price, even if the price goes up.
Want to read more related to this topic? You can also read these articles by clicking the links given below:
- What is a Call Option? A Beginner’s Guide to Trading Call Options
- What is Options Trading? A Beginner’s Guide to Financial Derivatives
When Was the First Forward Contract Invented?
It’s hard to say exactly where the first forward deal came from. But there is proof from the past that forward-like arrangements have been used for hundreds of years, mostly in commodity and agricultural markets.
For example, in ancient times, farmers and businessmen probably made oral deals to buy or sell crops at later dates. These deals were basically forward contracts that guaranteed them a certain price for their goods. Even though forward contracts didn’t become official until much later, the idea of protecting against unclear future prices has been an important part of business for a long time.
