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What is a Forward Contract?
A forward contract, or a forward, is a legal agreement to buy or sell an asset at a specific price on a specific date in the future. Since these contracts refer to an underlying asset which will be delivered in the future, they are also considered a type of derivative.
There are different types of forward contracts such as window forwards, long-dated forwards, non-deliverable forwards (NDFs), flexible forwards, etc.
How Forward Contracts Work
Forward contracts are used to set a specific price to avoid price fluctuations. The person who buys the forward contract enters a long position. The seller enters a short position. These are customized over-the-counter contracts created between the parties.
A forward contract also has an expiration date. The contract must be settled on this expiration date. In order to settle the forward contract, the selling party will deliver the underlying asset and the buying party will pay the price to take possession of the asset.
A forward contract has some main components. Below are few of them:
- Expiration Date : The forward contract must be settled by the expiration date of the forward contract. By this date, the asset must be delivered and paid for.
- Asset : This is the underlying asset in the contract that is to be sold by the buyer.
- Price : The price is the amount paid by the buyer on the expiration date of the forward contract when it is settled.
- Quantity : This is the amount the assets being transacted in the forward contract.
Forward contracts are used to protect one from potential losses. For instance, forward contracts are used in the oil industry where the prices fluctuate. A forward contract can lock-in a price for the number of barrels to be sold. Often oil prices drop suddenly and forward contracts can protect against such risks. Forward contracts can also be used to protect against fluctuating exchange rates in international trade.
For example, if there is an agricultural producer with one million bushels of corn to sell in six months to a different small country that doesn’t produce corns. The agricultural producer and the country enter into a forward contract to lock-in the price of $2 per bushel in 6 months. The contract will be settled by cash on the expiration date. In six months, there are three scenarios that might play out. First, the price doesn’t fluctuate. Second, the price might go down to $1 per bushel. Here the buyer would have made a huge profit by buying the corn at a lower price. Third, the price might go up to $3. Here, the producer would have made a larger profit.
However, since they used a forward contract, the price of $2 is locked in and thus, depending on the scenario, it will favor one party and not serve one party. Still, the certainty of the sale price that it provides often gives parties incentive to use forward contracts.
Forward contracts are also widely used based on speculation. If one party speculates a price fluctuation and a forward contract would lock-in a better price then it might can be used. If the forward price ends up being more than the change in price, the seller makes a profit.
You can read more on types of forward contracts here .
Forward Contract vs. Futures Contract
It is common to confuse a forward contract and a future contract. They are very similar as they are both used to agree on a specific price and quantity of an asset which is being transacted in the future. However, forward contracts and future contracts have certain differences. Here are few of them:
- Future contracts are standard contracts and are traded on centralized exchanges. In contract, forward contracts are customized.
- Forward contracts are settled on the set expiration date of the contract. Future contracts are traded whenever the exchange is open, or they are marked-to-market daily.
- Future contracts have initial margins or maintenance margins as they are traded day to day. This is different from forward contracts which are settled on one day.
- Since forward contracts are also speculative, they can be incredibly risky for the buyer.
- Future contracts are settled with cash. However, forward contracts are usually settled after the delivery of the asset however cash-settlement is also possible.
You can read more on future contracts here .
Advantages of a Forward Contract
Forward contracts can provide significant benefits to its users. Here are some advantages of using a forward contract:
- Certainty : A forward contract provides the benefit of certainty. Even if the currency or price fluctuates, the price has been locked in using the forward contract.
- Profits : Since forward contracts provides the possibility of speculative contracts, they can be used to make profits in risky environments. If one country speculates the price of oil will likely increase in the future, they can use a forward contract to buy the oil at the lower price in the future, likely saving a lot.
- Flexibility : Forward contracts provide flexible payment options. You can buy now and pay later using a forward contract. Therefore, you do not need immediate funds to make the purchase.
You can read more on when forward contracts are used, here .
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Disadvantages of a Forward Contract
Here are some disadvantages of using a forward contract:
- Risky for one party: Forward contracts work well for one party. The party that suffers the losses in the case of a price drop or increase is risking probable profits by getting into a forward contract.
- Loss : While forward contracts are speculative, they still work for one party. If one party has more information, capability to correctly speculate, or they just get lucky, they will make profits and the other party will face losses. As a result, it can lead to losses for one party.
- No Control of Future : The parties cannot accurately predict the future and since forward contracts lock-in the price and date of sale, they carry an inherent risk.
- Expiration date : Expiration dates are when the forward contracts must be settled. There is a possibility that one party might default.
- Product Quality : Since the contract is settled in the future, by the time the expiration date arrives, the product quality might not meet the buyer’s initial expectations. If the contract covers grain, beef, oil, etc. without seeing the product, they might not meet the quality standard.
You can read more on disadvantages of a forward contract here .
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