Knowledge is Having the Right Answer

Forward Contracts – What is a Forward Contract?

What Is a Forward Contract?

Forward Contract - Forward ContractsForward contracts are private agreements between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation.  However, its specific nature makes it particularly suitable for hedging.

The forward contract refers to the underlying asset that will be delivered on the specified date.  For this reason, it is considered a type of derivative.  Forward contracts can be used to lock in a specific price to avoid volatility in pricing. The party who buys a forward contract is entering into a long position.  The party selling a forward contract enters into a short position. If the price of the underlying asset increases, the long position benefits. If the underlying asset price decreases, the short position benefits.

How do Forward Contracts Work?

Let’s say the owner of an apple orchard expects to have 100,000 bushels of apples.  The apples will be harvested and ready for sale in three months’ time. At this point, there’s no way to know exactly how the apple price may change between now and then. So, the apple orchard owner enters into a forward contract with a buyer who makes apple juice.  The apple grower can lock in a set price per bushel for when it’s time to sell the crop.

The spot price of apples is what determines how this works out for the buyer and seller. The contract is fulfilled if the per bushel price at the time of sale is the same as the specified contract price. If the contract reaches its end and the spot price has increased, the seller would have to pay the buyer the difference between the forward price and the spot price. If the spot price has fallen below the forward price, the buyer would have to pay the difference to the seller.

Forward contracts have four main components to consider:

  • Asset: This is the underlying asset that is specified in the contract.
  • Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
  • Quantity: This is the size of the contract, and will give the specific amount in units of the asset being bought and sold.
  • Price: The price that will be paid on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.

Forward contracts are not traded on centralized exchanges. Instead, they are customized, over the counter contracts that are created between two parties. On the expiration date, the contract must be settled. One party will deliver the underlying asset, while the other party will pay the agreed-upon price and take possession of the asset. Forwards can also be cash-settled at the date of expiration rather than delivering the physical underlying asset.

(Source:corporatefinanceinstitute)

The Mechanics of Forward Contracts

Unlike standard futures contracts, a forward contract can be customized to a commodity, amount, and delivery date.

  • Commodities traded can be grains, precious metals, natural gas, oil, or even poultry.
  • Settlement – A forward contract settlement can occur on a cash or delivery basis.
  • Custom derivative – A forward contract is a custom derivative.

In summary, a forward contract is an agreement between two parties.  The agreement is to buy or sell an asset at a specified price on a future date.  The contract can be tailored to a specific commodity, amount, and delivery date.  Forward contracts do not trade on a centralized exchange.  As such, they are considered over-the-counter (OTC) instruments.

Forward Contracts Versus Futures Contracts

Both forward contracts and futures contracts involve an agreement to buy or sell an asset at a set price in the future. But there are slight differences between the two. A forward contract does not trade on an exchange.  A futures contract does. Settlement for the forward contract takes place at the end of the contract.  The futures contract p&l settles on a daily basis. The key difference is that futures contracts exist as standardized contracts.  They are not customized between counterparties like forward contracts.

Forward Contracts

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is high counterparty risk. This means there may be a chance that one party will default.

Futures Contracts

Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract.  First, futures contracts—also known as futures—are marked-to-market daily.  This means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.  Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This dramatically lowers the probability of default.  As a matter of fact, defaults almost never occur. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.

The market for futures contracts is highly liquid.  This gives investors the ability to enter and exit whenever they choose to do so.  These contracts are frequently used by speculators, who bet on the direction in which an asset’s price will move.  They are usually closed out prior to maturity and delivery usually never happens. As a result, cash settlements usually takes place.

Example of a Forward Contract

Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

  • It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
  • It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
  • It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

Source: ibid

Different Types of Forward Contract

There are four major types of forward contract:

  • Closed Outright Forward
  • Flexible Forward
  • Long-Dated Forward
  • Non-Deliverable Forward

Closed Outright Forward.

Also called a “European,” “fixed” or “standard” contract, the “closed outright forward” is the simplest type of forward contract.  In it, the counterparties agree to exchange funds on a specified date in the future (the “value” or “maturity” date). The exchange rate is fixed at the time the transaction is agreed and is typically the spot rate on the transaction date plus a premium or discount known as “forward points,” derived from the interest rate differential between the two currencies.

Closed outright forwards are widely used by businesses to hedge against the risk of losses due to adverse exchange rate movements. However, hedging with closed outright forwards makes it impossible to benefit from advantageous exchange rate movements. Closed outright forwards also offer no flexibility about the date of settlement. Both parties are legally obliged to exchange the funds on the value date. Businesses that need more flexibility over payment terms may prefer open or “flexible” forward contracts.

Flexible Forward.

In a flexible forward contract, the counterparties can exchange funds on or before the maturity date. The funds can be exchanged in one go (“outright”). Alternatively, several payments may be made over the course of the contract provided that the entire amount is settled by the maturity date. This can give businesses more flexibility in managing their FX cash flow. A window forward is similar to a flexible forward, but exchanges of funds can only be made within an agreed “window” of a few days or weeks.

Long-Dated Forwards.

Forward contracts, whether closed or flexible, are typically for relatively short periods of time such as three months. However, some lock in exchange rates for a year or more. These longer-term contracts are known as “long-dated forwards.” Except for their distant maturity dates, long-dated forwards are similar to shorter-term forwards, though forward points may be larger because locking in an exchange rate for a longer-term increases counterparty interest rate risk.

Non-Deliverable Forward.

Most forward contracts entered into by businesses involve the physical exchange of funds. However, there is a type of forward contract for which the principal benefit is that there is no physical exchange. In a “non-deliverable forward” the counterparties agree to settle only the difference between the contract exchange rate and the spot rate on the maturity date. Settling non-deliverable forwards thus involves only relatively small amounts of money. They are typically used by businesses to hedge currency risk when capital and exchange controls are involved, or when the local currency is not widely traded.

Source: americanexpress.com

Risks with Forward Contracts

The market for forward contracts is huge.  Many of the world’s biggest corporations use them to hedge currency and interest rate risks. However, the details of forward contracts are restricted to the buyer and seller.  They are not known to the general public.  Therefore, the size of this market is difficult to pinpoint.  The large size and unregulated nature of the forward contracts market leave it vulnerable.  It may be susceptible to a cascading series of defaults in the worst-case scenario. Banks and financial corporations mitigate this risk by being very careful in their choice of the counterparty.  Nevertheless, the possibility of large-scale default does exist.

Another risk that arises is that they are only settled on the settlement date.  They are not marked-to-market like futures. Risk occurs when the forward rate specified in the contract diverges widely from the spot rate at the time of settlement.  The financial institution that originated the forward contract is exposed to a greater degree of risk.  The possibility of default or non-settlement by the client is greater than if the contract were marked-to-market regularly.

Forward contracts attract two types of buyers: hedgers and speculators. Typically, more hedgers than speculators participate in forward contracts.

For Hedgers

Hedgers enter into forward contracts to stabilize revenues or costs of their business operations. Instead of seeking profit, gains are used to offset losses in the market for an underlying asset.

For Speculators

Speculators try to maximize their profits by “betting” on which way the prices will go. They aren’t interested in buying or selling the underlying asset. Instead, they hope to profit on the forward contract itself by “betting” on the direction the price will go.

The Bottom Line

Forward contracts serve a purpose for both buyers and sellers.  They help manage the volatility associated with commodities and other alternative investments. They tend to be riskier for both parties involved because they’re over-the-counter investments. Although similar, they’re not to be confused with futures contracts. Those are more accessible to everyday investors who want to look beyond stocks and bonds.

  • For buyers, forward contracts lock in prices.  This enables them to predict and control variable costs of commodities. They can hedge against volatility in the currency exchange rate.  They can lock in the rate using a forward contract.
  • For sellers, forward contracts enable them to project cash flow.  It identifies the value of a future asset when the forward contract is struck. Forward contracts obligate buyers to take possession of the commodity upon the delivery date.  Sellers also have certainty of who they are delivering their commodities to and by when. They can use this information for business planning and management purposes and reduce their risk.
  • Private – Because forward contracts are unregulated, they are also private. Buyers and sellers have the freedom to strike whatever price they deem are fair and acceptable.  Yet, they have no obligation to disclose that price to anyone else.

Up Next: What Is the Average Collection Period?

The average collection period (ACP) is the amount of time it takes for a business to receive outstanding payments.  These are payments owed by its clients for goods or services in terms of accounts receivable (AR). Companies calculate the average collection period to make sure they have enough cash on hand to meet their financial obligations. The average collection period is calculated by dividing the average balance of accounts receivable by total net credit sales for the period and multiplying the quotient by the number of days in the period.  Collection periods are most important for companies that rely heavily on receivables for their cash flows.

Leave a comment

Your email address will not be published.