A forward contract is a customized agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. Forward contracts are highly adaptable, making them a popular tool for managing risk and speculative ventures alike.
Key Points to Note
- Forward contracts are customizable derivative agreements designed between two parties to buy or sell an asset at a prescribed price on a future date.
- These contracts can be tailored to specific commodities, quantities, and delivery dates.
- Since they do not trade on a centralized exchange, they are considered over-the-counter (OTC) instruments.
- Forward contracts are particularly useful for hedging against price fluctuations in commodities such as grains, precious metals, natural gas, and more.
- Due to their non-standardized nature, financial institutions party to these contracts are exposed to higher levels of settlement and default risk compared to standardized contracts.
Unpacking Forward Contracts
Unlike standardized futures contracts, a forward contract can be uniquely tailored to the commodity, amount, and delivery date of the trading parties’ choosing. The underlying assets commonly include grains, precious metals, natural gas, and oil.
Forward contract settlements can be conducted on either a cash or delivery basis but are never traded on centralized exchanges. This OTC nature permits customization but also elevates the risk of default since there’s no centralized clearinghouse.
Consequently, forward contracts remain less accessible to retail investors when compared to futures contracts.
Forward Contracts vs Futures Contracts
While both forward and futures contracts involve agreements to buy or sell an asset at a future date, several differences exist:
- Trading Platform: Forward contracts are OTC instruments, whereas futures contracts trade on exchanges.
- Settlement: Forward contracts settle at the end of the contract term, while futures contracts have daily settlements.
- Standardization: Futures contracts are standardized and not customizable, unlike forward contracts.
Real-life Illustration of a Forward Contract
Imagine an agricultural producer planning to sell two million bushels of corn six months from now but worried about a possible price drop. They could enter into a forward contract with a financial institution to sell corn at $4.30 per bushel in six months, settling on a cash basis.
After six months, three scenarios could unfold for the spot price of corn:
- Spot price equals $4.30 per bushel: No payment is owed by either party; the contract simply closes.
- Spot price rises to $5 per bushel: The producer would owe the financial institution $1.4 million.
- Spot price falls to $3.50 per bushel: The financial institution would owe the producer $1.6 million.
Risks and Challenges in Forward Contracts
Forward contracts have significant utility in hedging and financial strategizing, but they carry specific risks:
- Default Risk: Given their bespoke nature, any major failure could initiate a chain-reaction of defaults, especially evident in large-scale agreements.
- Lack of Market Transparency: Restricted to specific buyer-seller information, making it complex to determine the market size.
- Settlement Risk: Financial instruments are not marked-to-market; hence, mismatches can pose risks at settlement.
- Absence of a Clearinghouse: The non-standard framework poses substantial risks compared to futures, which are market-monitored.
Related Terms:
References
- CME Group. “Futures Contracts Compared to Forwards”.
