Forward Contracts: What Are They and How Do They Work?

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Forward Contracts What Are They and How Do They Work?
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What Exactly Are Forward Contracts: We explain all in this authoritative article

Investors now have a whole host of financial products to choose from when diversifying their portfolios. One such financial product that has been slowly rising in popularity among investors are forward contracts.

A forward contract is an agreement between two parties to buy or sell an underlying asset at an agreed price in the future (usually up to 12 months ahead). Simply put, think of it as a ‘buy now, pay later’ product.

Forward contracts are more popular among currency and commodity traders looking to protect themselves from currency market volatility. However, traders can also enter into forward contracts with other assets such as equities, indices, treasuries and real estate.

What Is a Forward Contract?

A forward contract is a derivative product that enables two parties to enter into a contractual agreement between a future transaction of an asset. In the contract, party A and party B will establish and agree on fundamentals such as the price, the quantity, and the delivery date of the asset. If party A or party B agrees to buy the asset, they will take a long position. If party A or party B sells the asset, they will take a short position.

When looking to hedge against market uncertainty, forward contracts have long been a go-to option (they’ve supposedly been in use since the middle ages!). Throughout most of their history, their use was for seasonal agricultural commodities, such as wheat and corn. Nowadays, investors can use forward contracts for a multitude of different assets.

Individuals may use a forward contract when purchasing a property in a foreign country, whereas a business may use a currency forward contract to lock in prices on future payments. Today, it’s also still common for commodity producers to enter into forward contracts to help hedge against future price fluctuations.

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Characteristics of a Forward Contract

There are some key characteristics to a forward contract that all investors should be aware of. These include:

  • They are private and legally binding agreements between each party involved in the deal.
  • They aren’t processed through a clearing house and do not trade on a centralised exchange. Instead, they trade through over-the-counter (OTC) markets.
  • Forwards do not come under the jurisdiction of any regulatory agency, as they trade through OTC markets.
  • Parties can customise the contract to satisfy their requirements as they are a non-standardised entity.
  • They are most notably used within the commodities market to trade a variety of raw materials such as oil, sugar and gold. However, investors can also use them for other trading products like currencies, equities and indices.

The Different Types of Forward Contracts

There are several different types of forward contracts that help manage foreign exchange risk. These include:

  • Window Forwards 

This type of forward enables buyers to purchase foreign currencies within a range of settlement dates – known as windows. The premise behind window forwards is to achieve a better and more convenient exchange rate than what you might achieve with a standard forward contract. 

  • Long-Dated Forwards

Long-dated forwards have significantly longer settlement periods than standard forward contracts. Long-dated forwards allow parties to set a delivery date up to ten years into the future, whereas a standard forward contract is generally up to twelve months. Both contracts are essentially the same; it’s just that long-dated forwards have a lengthier settlement date.

  • Non-Deliverable Forwards (NDFs)

NDFs are different from other forward contracts because they don’t involve the physical exchange of funds. Instead, the parties involved settle the difference in value between the two currencies at the due date. Parties entering into NDFs usually enter into this type of agreement with a small amount of money. 

  • Flexible Forward

In this type of forward, parties can exchange funds before the actual settlement date by exchanging the funds outright or opting to make several payments before the due date. Investors looking for more flexibility usually select this type of forward.

  • Closed Outright Forward

Out of all the forward types, this is generally the most straightforward option. Often referred to as European contracts or Standard Forward Contracts, they work by allowing both parties to exchange currencies at a specified date in the future. The exchange rate is locked in once the transaction is agreed upon, which helps investors hedge against the risk of losses.

Are Forward Contracts Traded on an Exchange?

As we briefly touched on earlier, forwards aren’t traded on an exchange. Instead, they trade through OTC markets. They don’t trade on an exchange because they are non-standardised contracts, and the two parties involved must customise the contract to their needs.

As a forward contract does not trade on a centralised exchange, it means they are not regulated. As they aren’t subject to regulation, the parties involved in the contract are susceptible to both counterparty credit risk and market risk.

Futures, on the other hand, are standardised contracts that trade on a centralised exchange. There’s also no counterparty risk involved as the exchange clearing house acts as the counterparty to both parties in the contract.

What Are the Pros and Cons of a Forward Contract?

Forward contracts are not suitable for everyone. Therefore, it’s important to weigh up the advantages and disadvantages associated with them before you begin to think about using them. To help you further understand more about these financial products, let’s take a quick look at some of the pros and cons of a forward contract:

Pros of a Forward Contract

Increased Certainty: 

By locking in an exchange rate, you can trade or purchase assets with increased certainty. Using forward contracts means you won’t have to worry about factors like changes in market inflation or interest rates that could affect a currency’s value.

More Customisation:

As they are non-standardised contracts, both party members can customise the agreement to meet their individual needs. The parties involved have more flexibility to customise aspects like the number of units of the asset and the contract’s expiration date.

Hedge Your Exposure:

Using these types of contracts can help hedge your exposure and reduce your risk to hard market periods and potential currency exchange rate fluctuations. Hedging also means long-term traders won’t have to keep monitoring the markets, saving valuable time.

Simple to Set Up:

As each party can customise the contract to their needs, forwards are relatively easy to understand and set up. This simplicity is why these types of derivatives are popular for hedging against risk.

Cons of a Forward Contract

You Can Miss Potential Gains:

Although hedging can help prevent potential losses, it can also work against you. Unfortunately, if the currency moves in your favour, you won’t be able to realise these gains, as you would have already locked in your fixed-rate when you entered into the contract.

Counterparty Risks: 

As forwards aren’t traded on an exchange, there is a degree of counterparty risk. If a buyer cannot adhere to its contractual obligations due to financial issues, then the likelihood of default on behalf of the counterparty becomes significant. A forward contract will never be risk-free.

No Regulation:

Again, as forwards aren’t traded on an exchange, they are not bound by any regulatory authority. As there is no regulation, there is less available public information and a higher chance of outdated information.

Forward Contract vs Futures Contract

People often get forward and futures contracts confused and believe that they are the same thing. However, this is not true. Although they do certainly share some similarities, they do have some notable differences.

Forward contracts are a non-standardised contractual agreement between two parties to trade a certain underlying asset at a specific price and time in the future. They are traded privately over-the-counter, not on an exchange. As a result, both parties involved have more flexibility to customise certain parts of the contract.

In contrast, a futures contract is a standardised version of a forward contract that publicly trades on a centralised exchange. Both parties cannot customise publicly-traded contracts. However, they are not subject to counterparty risk, and government regulation helps protect the parties involved.

Although the two types of contracts serve more or less the same purpose; to allow traders to buy or sell an underlying asset at a given price at a given time. How that contractual agreement is delivered has some notable differences.

Example of a Forward Contract

Let’s say a company needs to sell 500,000 U.S. dollars and buy British pounds in three months to reduce market exposure.

The company is fearful that the U.S. dollar may weaken against the British pound, so they decide to enter into a forward contract to lock in an exchange rate. By doing this, they know that they’ll receive their fixed amount of £360,000 at the end of the contract regardless of which direction the market moves.

The advantage for this company is that if the U.S. dollar does weaken against the British pound over the course of the transaction, their contract protects their fixed exchange rate. For a transaction of this size, the savings could end up being significant if the market moves against them.

However, the flip side to this is if the markets do happen to move in the companies favour, then there is the potential of opportunity loss. The company would miss out on the favourable exchange rate, as they are obligated to exchange at the fixed rate they agreed on in the contract.

Despite the fact that a forward contract date can work with or against you at the end of the settlement date, they are still beneficial because it helps remove exposure and provides increased certainty, which is the main benefit of entering into a forward contract.

Forward Contract FAQ

Why are forward contracts useful?

They are particularly useful for investors looking to hedge against a change in an underlying asset price. They can also help speculate on future prices of assets. However, the non-standardised nature of forward contracts makes them more suitable for hedging. If you trade the forex markets, then forwards can also help exploit arbitrage opportunities in the cost of carrying different currencies.

Overall, they are beneficial to both parties involved. It can help eliminate the uncertainty about future changes in an asset’s price and allow both parties involved to plan ahead with confidence.

What Is a Short Date Forward? 

This type of forward is a contractual agreement between two parties that will expire in less than one year. It is most commonly used in trading currencies and involves trading a currency at a specified spot date before the settlement spot date. Investors can use them as a speculative investment vehicle or to hedge their risk.

What is the difference between a future and a forward contract?

Both of these derivatives are similar in that they both allow traders to buy or sell an underlying asset at a given price at a given time. However, they do have some notable differences. These include:

The Structure

Forward contracts are non-standardised, and both parties can customise the agreement. Conversely, futures are standardised contracts that trade on a futures exchange. As they trade on an exchange, both parties must abide by the contract terms set by the exchange, and neither party can make customisations.

Counterparty Risk

A forward contract has a higher counterparty risk in comparison to a futures contract. Each party member entering into a forward contract must evaluate the other party’s default risk before entering into a contractual agreement. An evaluation of default risk is not necessary for a futures contract.

Transaction Facilitation 

Forward contracts trade through OTC markets. As a result, they do not come under regulation. Futures, on the other hand, are quoted and traded over the stock exchange, which means the government does regulate them.

Why Is the Initial Value of a Forward Contract Set to Zero?

Unlike certain other derivative instruments, forwards don’t have a down payment. As there is no exchange of money in the initial agreement, there is no value attributed to the contract, and as a result, the initial value is zero.

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