A forward contract is a special agreement where you promise to buy or sell something, like stocks or commodities, at a certain price on a specific date in the future. It helps protect investors from the changing prices of currencies, bonds, stocks, and other assets. It’s sometimes called a “forward outright” contract.
Understanding Forward Contracts
Unlike regular futures contracts, a forward contract is made to fit specific needs like the type of commodity, how much of it, and when it will be delivered. The things traded could be grains, valuable metals, natural gas, oil, or even poultry. When a forward contract is settled, it can happen with cash or by delivering the goods.
Forward contracts aren’t traded on a central exchange, so they’re called over-the-counter (OTC) instruments. Because they’re OTC, it’s simpler to adjust the terms to what’s needed. However, the risk of default is higher because there’s no central clearinghouse to manage transactions.
Forward Contracts vs. Futures Contracts
Forward and futures contracts both involve agreeing to buy or sell a commodity at a fixed price in the future, but they have some differences. Unlike forward contracts, futures contracts are traded on an exchange.
Settlement for a forward contract happens at the end of the contract, whereas for futures contracts, it occurs daily. The key distinction is that futures contracts are standardized and not customized between parties.
Example of a Forward Contract
Let’s look at an example of a forward contract. Imagine a farmer who has two million bushels of corn to sell in six months. They’re worried that the price of corn might drop, so they make a deal with their bank to sell the corn for $4.30 per bushel in six months, settling the payment in cash.
After six months, the price of corn could be:
- Exactly $4.30 per bushel: In this case, neither the farmer nor the bank owes money to each other, and the contract ends.
- Higher than $4.30, like $5 per bushel: The farmer owes the bank $1.4 million, which is the difference between the current price and the agreed price of $4.30.
- Lower than $4.30, maybe $3.50 per bushel: The bank pays the farmer $1.6 million, the difference between $4.30 and $3.50 per bushel.
Risks of Forward Contracts
The market for forward contracts is large because many of the world’s biggest companies use them to protect themselves from currency and interest rate changes. However, since only the buyer and seller know the details of these contracts and they’re not public, it’s hard to tell how big the market is.
Because the forward contracts market is big and not regulated, it could face a chain of defaults if things go wrong. Banks and financial companies try to avoid this risk by being careful about who they do business with, but the danger of large-scale defaults still exists.
Another risk with forward contracts is that they’re settled only on the agreed date and not regularly adjusted like futures contracts. So, if the agreed price in the contract is very different from the actual price when it’s settled, the financial institution that made the contract faces more risk if the client doesn’t pay or defaults, compared to if the contract was regularly updated.
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