Author: Sarthak Bhalerao
Table of Contents
- What is a Forward Contract?
- How do Forward Contracts work?
- Risk of a Forward Contract
What is a Forward Contract?
A forward contract, more commonly known as just forward, is an agreement between two parties to buy or sell an asset at an agreed-upon price on a specific date in the future. As the forward contract refers to an underlying asset that will be delivered in the foreseeable future, it is considered as a type of derivative. A forward contract is mostly used in hedging or speculation, but its nature makes it more apt for hedging. These contacts are not traded on exchanges but rather are over the counter(OTC) instruments.
Understanding Forward Contracts
A forward contract can be customized according to the commodity, amount, and delivery date. Commodities traded can be grains, metals, natural gas, oil, etc. As stated earlier, forward contracts are of an OTC nature which makes it easy and feasible for them to be customized. But as there isn’t any centralised exchange involved, the risk factor is considerably higher. Forward contracts use specific periods to avoid volatility. The buyer enters a long position, and the seller enters a short position. If the price of the asset increases, the long position benefits and if the price falls, the short position benefits.
There are 4 main components that are considered.
- Asset: The underlying asset which is specified in the contract
- Expiration date: The contract will no longer be valid past this date.
- Quantity: This is the size of the contract and will consist of the units of the assets being bought and sold
- Price: The agreed-upon price that will be paid on the expiration date. This also includes the currency in which the payment is to be made.
Risk of a Forward Contract
The forward contracts market is huge as many big companies use it for hedging and interest rate risks. However, the details of the forward contract are restricted to the buyer and seller. The general public does not know details regarding the contract. As the market size is very large and the contracts are unregulated, they are vulnerable to many faults in the worst-case scenario. Another risk arises from the non-standard nature of the contracts that are only settled on the expiration date. The forward rate specified can widely differ as compared to the spot rate. In such scenarios, the financial institution that originates the contract is exposed to greater risk.
Assume that an agricultural producer has two million milk cartons to sell six months from now. He is concerned about a potential decline in the price of milk. He thus enters into a forward contract with its financial institution to sell two million milk cartons at a price of $5 per carton in six months, with settlement on a cash basis. After 6 months, the spot price has 3 possibilities:
- Price is exactly $5: No money is owned or owed, and the contract is closed.
- Price is higher than $5, say $5.5: The producer owes the institution $1 million.
- Price is lower than $5, say $4.3: The financial institution will pay the producer $1.4 million.