What is a Forward Contract? And How Does it Work?

A Brief History of Forward Contracts

Forward contracts have been around since the time of the Greeks and Romans. There is evidence that they were widely employed in Europe during the Middle Ages, and Europeans carried on the forward contract practice in the New World.

Forward contracts were used to stockpile necessary items that could subsequently be resold for a profit. Buyers would get wheat, maize, or other commodities upon contract delivery, pay the forward price (agreed upon in the contract), and hope that demand for the product would increase, allowing them to raise prices, resale it, and profit.

What is a Forward Contract?

A forward contract, sometimes abbreviated as “forward,” is an agreement to buy or sell an asset at a predetermined price on a future date. The forward contract is a derivative since it refers to the underlying asset delivered on the specified date.

To reduce price fluctuation, forward contracts can be utilized to lock in a set price. A long position is taken by the buyer of a forward contract, while the seller of a forward contract takes a short position. The long position gains if the price of the underlying asset rises. Suppose the price of the underlying asset falls, the short position benefits.

How do Forward Contracts Work?

There are four essential components to consider with forwarding contracts. The four elements are as follows:

  • Asset: This is the underlying asset that the contract specifies.
  • Contract Expiration Date: When the agreement is finalized, the asset is delivered, and the deliverer is paid, the contract must have an expiration date.
  • Quantity: This is the contract’s size, and it specifies the quantity of the item being purchased and sold in units.
  • Price: You must also provide the price that will be paid on the maturity/expiration date. This will also indicate the currency that will be used to make the payment.
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On centralized exchanges, forwards are not exchanged. Instead, they are made-to-order, over-the-counter contracts between two parties. The contract must be settled by the expiration date. The underlying asset will be delivered by one party, while the other will pay the agreed-upon amount and gain possession of the asset. Instead of providing the physical underlying asset, forwards might be settled in cash at the expiration date.

What are Forward Contracts Used For?

The basic purpose of forwarding contracts is to protect against prospective losses. They give participants the ability to lock in a price for the future. This guaranteed price might be critical, especially in businesses where prices are prone to severe volatility. For example, in the oil business, engaging in a forward contract to sell a specified quantity of barrels of oil can be used to safeguard against price volatility. When making substantial foreign transactions, forwards are also widely utilized to hedge against changes in currency exchange rates.

Forward contracts can also be used just as a form of speculation. Because forwards are formed by two parties and are not available for trade on centralized exchanges, it is less frequent than using futures.  A speculator may take a long forward position if they anticipate the future spot price of an asset will be greater than the forward price today. They will earn if the future spot price is higher than the agreed-upon contract price.

Forward Contract Example

Old MacDonald had a farm, and he raised a lot of maize on that property. He expects to harvest 500 bushels of corn this year, which he can sell at whatever price per bushel is available at harvest time – or lock in a price now.

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To make their cornflakes, the Crunchy Breakfast Cereal Company needs a lot of corn. They send a representative to Old MacDonald’s farm and offer him a fixed price for 500 bushels of grain to be delivered at harvest.

Old MacDonald will earn the delivery price if he can deliver 500 bushels of corn by a certain date under the forward contract. If he can produce 500 bushels of corn at the projected delivery price, he can plan this year’s farm revenue.

Crunchy Breakfast Cereal Company can manage variable costs (such as corn) to create their breakfast cereal since they have a forward contract. Knowing the price of maize ahead of time allows them to keep consumer pricing consistent. They risk overpaying Old MacDonald for his corn, but it’s a risk they’re prepared to accept to keep their cornflake’s costs stable and maintain market share

Forward Contracts vs. Futures Contracts

Both forward contracts and futures contracts are derivative instruments, with a derivative being a contract whose value is determined by the value of another underlying asset. They do, however, differ in several respects.

Elements of Forward Contracts

Forward contracts are a type of derivative that is not regulated. Banks frequently execute forward contracts on behalf of their customers (particularly currency forward contracts), while other contracts may be drafted privately.

Elements of Futures Contracts

Futures contracts are regulated in the United States by the Commodities Futures Trading Commission, and trades must be conducted on a registered commodities exchange floor. The National Futures Association requires firms and individuals that provide advice or trade futures to be registered. Clients must first register with the broker of their choice to make a futures order.

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Both the buyer and the seller use the futures exchange as a clearinghouse and counterparty. Rather than dealing directly with each other, both buyer and seller trade with the exchange (reducing the risk of counterparty default). There is a larger risk of default because there is no central clearinghouse for forwarding contracts.

Summary

As discussed above, a forward contract is an agreement between two parties to trade a predetermined quantity of an asset for a predetermined price at a future date. Futures and forwards are quite similar, yet there are several major differences when the underlying asset’s price rises on the maturity/expiration date, a forward long position benefits.

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