Forward contract

3 key takeaways

• Forward contracts are private agreements that allow the parties to lock in a price for an asset to be traded in the future.
• These contracts are customizable, meaning the terms, including the asset, quantity, and delivery date, can be tailored to the needs of the parties involved.
• Unlike futures contracts, forward contracts are traded over-the-counter (OTC) and are not standardized or regulated by an exchange.

What is a forward contract

A forward contract is a type of derivative financial instrument in which two parties agree to buy or sell an asset at a predetermined price on a specific date in the future. This agreement is tailored to the specific needs of the parties involved, including the quantity of the asset, the price, and the date of delivery. Forward contracts are commonly used in commodities, currencies, and financial markets to hedge against price volatility or to speculate on future price movements.

Importance of forward contracts

Forward contracts play a significant role in financial markets and business operations:

• Price Stability: They allow businesses to lock in prices for commodities and raw materials, protecting against future price fluctuations.
• Hedging: Investors and companies use forward contracts to hedge against potential losses from adverse price movements.
• Customization: The flexibility to customize terms makes forward contracts suitable for a wide range of transactions.

How forward contracts work

Forward contracts work through mutual agreement between two parties, specifying the terms of the future transaction. Here’s a step-by-step breakdown of how they function:

1. Negotiation: The buyer and seller negotiate the terms of the contract, including the asset to be traded, the quantity, the price, and the delivery date.
2. Agreement: Once the terms are agreed upon, a contract is drawn up, detailing all the agreed-upon conditions.
3. No Initial Exchange: No money or asset is exchanged upfront when the contract is signed.
4. Delivery and Settlement: On the specified future date, the seller delivers the asset to the buyer, and the buyer pays the agreed-upon price. Alternatively, the contract can be settled in cash, depending on the terms.

Example of a Forward Contract

To illustrate, consider a wheat farmer and a bakery:

• Farmer: Agrees to sell 1000 bushels of wheat at $5 per bushel to the bakery in six months.
• Bakery: Agrees to buy the wheat at the agreed price, regardless of the market price at the time of delivery.
• Outcome: If the market price of wheat rises to $6 per bushel, the bakery benefits by paying $5 per bushel, while the farmer misses out on the higher price. Conversely, if the price drops to $4 per bushel, the farmer benefits, and the bakery pays more than the market price.

Real world application

Forward contracts have practical applications across various industries:

• Commodities: Producers and consumers of commodities like oil, wheat, and metals use forward contracts to stabilize prices and manage risk.
• Currency Exchange: Businesses engaged in international trade use forward contracts to hedge against currency exchange rate fluctuations.
• Interest Rates: Financial institutions use forward rate agreements to hedge against interest rate movements, ensuring stable future borrowing costs.