Forward Contracts

• Article photo, courtesy of CEPR

When it comes to managing financial risks or speculating on future prices, businesses and investors often turn to a variety of financial instruments. One such tool that has gained widespread usage, especially in the world of international trade and finance, is the forward contract. But what exactly is a forward contract, and how does it work? Let’s dive into this powerful financial instrument and explore its significance in the financial world.

What is a Forward Contract?

A forward contract is a customized financial agreement between two parties to buy or sell an asset at a predetermined price on a specified future date.

Key Features of Forward Contracts

Customization: One of the most appealing aspects of forward contracts is their flexibility. The terms of the contract, including the quantity, price, and delivery date of the asset, are negotiated and agreed upon by the parties involved. This differs from standardized futures contracts, which are traded on exchanges with set terms.
Over-the-Counter (OTC) Nature: Forward contracts are typically traded over-the-counter, meaning they are not listed on formal exchanges like futures contracts. This makes forward contracts less liquid, as they cannot be easily traded or transferred to third parties. However, the OTC nature also allows for more tailored agreements.
Non-Marketability: Since forward contracts are private agreements, they are not marketable, meaning they cannot be easily bought or sold in secondary markets. This can make them less flexible compared to exchange-traded instruments.
No Initial Margin Requirement: Unlike futures contracts, forward contracts do not require an initial margin deposit or daily marking to market. As a result, they can expose parties to significant credit risk, especially if one party defaults before the contract matures.
Settlement and Delivery: Forward contracts can be settled either through physical delivery of the underlying asset or through cash settlement, depending on the agreement. In physical delivery, the actual asset is exchanged on the settlement date. In cash settlement, the difference between the contract price and the market price on the settlement date is exchanged, eliminating the need for actual delivery.

Types of Forward Contracts

1. Currency Forward Contracts: These are used by companies or individuals who want to hedge against future fluctuations in exchange rates. Currency forward contracts are particularly useful for importers and exporters, allowing them to lock in exchange rates for future transactions.
2. Commodity Forward Contracts: These contracts involve the buying or selling of physical commodities like oil, metals, or agricultural products at a future date. They are often used by producers or consumers of the commodity to protect themselves against price volatility.
Interest Rate Forward Contracts: These contracts involve agreements to borrow or lend a certain amount of money at a predetermined interest rate on a future date. Businesses use these contracts to hedge against changes in interest rates.
Equity Forward Contracts: These contracts allow investors to lock in a future sale or purchase of a specific amount of stock at a set price. This can be beneficial in hedging against stock price volatility.

How Do Forward Contracts Work?

Let’s take an example to illustrate how a forward contract functions:

Imagine a farmer who grows wheat. He knows that in six months, his crop will be ready for harvest, but he’s worried about the potential fall in wheat prices by that time. To mitigate this risk, the farmer enters into a forward contract with a wheat buyer (e.g., a food processing company). The contract specifies that the farmer will sell a certain amount of wheat to the buyer at $200 per ton in six months, regardless of what the market price of wheat is at that time.

Riks Involved with Forward Contracts

While forward contracts can be a valuable tool for managing financial risk, they also come with certain drawbacks:

1. Credit Risk: Since forward contracts are not traded on regulated exchanges, there is always the risk that one party may default on the agreement. This credit risk is higher in forward contracts compared to futures contracts, which are backed by exchanges and clearinghouses.
2. Illiquidity: Forward contracts are not as easily transferable or liquid as exchange-traded instruments like futures. This means that the parties involved are typically committed to holding the contract until the settlement date.
3. Lack of Transparency: Because forward contracts are private agreements, there is less price transparency compared to contracts traded on public exchanges. The lack of a standardized market price may make it more difficult for parties to accurately gauge the value of the contract.