Contracts are a legally binding document that takes place between two or more parties. However, there are several classifications to those contracts. 

One of these contracts is the forward contract. Forward Contracts are those contracts that are sometimes used as derivatives for future agreements. Forward contracts are primarily hedged on speculation and are the best solution when it comes to hedging.  

This blog is going to talk about the different aspects of forward contracts and how it has been used. You will also learn in detail about the differences between this and future contracts.  

What is a Forward Contract?

Forward contracts buy and sell assets and agreements at a specific price on a specific date for futuristic purposes. Forward contracts consist of underlying assets which can be delivered on a specific date as a derivative.  

The primary purpose of a forward contract is to avoid any form of volatility in pricing. If you buy a forward contract before entering into a long-term contractual position, the parties often selling the contract end up in a short position. 

However, if the price of the underlying asset increases, then in that case, it is immensely beneficial for long positions. Once the underlying asset price decreases, the short position benefits from those.  

How Does a Forward Contract Work?

You might be wondering how to make a forward contract work. Well, there are ways you can do that. A forward contract consists of four main components. They are  

Asset

It talks about the property or resources specified in the contract.  

Expiration Date

The contract needs an end date to settle the agreement get the asset delivered and get the deliverer to get paid.  

Quantity

This essentially talks about the size of the contract where it specifies the amount of assets in units that are bought and sold.  

Price

The price of these assets would be paid based on the date specified. The price of these assets specifically depends upon the maturation and expiration date of the asset. The price also entails the currency the payment will be rendered in.  

Remember that forwards are not centralized forms of exchanges. They are instead customized through various counter contracts. These counter-contracts are created between two parties. However, on its expiration date, the contract should get settled in no time. Forward contracts should be settled with cash before the expiration rather than after delivering the physical underlying assets.  

Usage of Forward Contracts

Primarily the forward contracts are used to hedge against any form of potential losses. They help the participants to lock in a price in the future. This piece of guaranteed price proves important in different industries which sometimes face the case of price volatility.  

To take as an example, in the oil industry, if you enter into a forward contract to sell a specific amount of oil. This process can be used against any kind of potential downward swings coming from the future from these oil prices. Hence, forwards are primarily used to hedge against any changes in the currency exchange rates in terms of international purchases.  

Forward contracts are even sometimes used for speculation. It is much more common to use them in the future as they are primarily created by two main parties. Sometimes, if the speculator believes that the future price may get higher than what it is today, they might enter into a long-forward position of a contract. Once the future spot price is greater, then the agreed-upon contract will profit altogether.  

Forward Agreement and a Forward Contract: Key Differences

At a glance, the terms future and forward might sound very similar to one another. They both involve various agreements talking about the specific price and quantity of an underlying asset. This underlying asset should be paid in the future on a specified date.  

However, there are some differences that we should keep in mind. They are:  

• Forward contracts are generally customized. It is a private contract between two parties with higher counterparty risk than in the future with clearing houses.  
• Forward contracts are primarily settled on a single expiration date. Forward agreements on the other hand are marked based on a daily market basis. These can be traded at any point in time when the market is open.  
• Since forwards are primarily settled on one single date, they are not associated with initial margins or other maintenance margins.  
• Both these contracts talk about asset delivery and other settlements in cash. Physical delivery is most common in forwards. On the other hand, cash settlements are much more common in future prospects.  

Why Should We Use Forward Contracts?

Forward contract comes with several advantages. The advantage of a forward contract is to lock up the pricing of a particular type of asset. It allows you to risk management methods and ensures that you can sell the asset with your chosen target price.

Forward contracts also deal with a way to lock in pricing. Suppose you are an owner of an orange juice company, a forward contract in that front helps you to buy orange supplies you might need to continue making the juice at a given price.  

Moreover, it’s important to remember that on both sides of the transaction, the goal mainly lies in creating a hedge against volatility. This would also come in handy when it comes to building around specific pricing.  

Remember, forward contracts are often used in connecting with assets that might experience a wide range of price swings in the near or far future. Commodities like wheat, precious metals, and other foreign currencies play a crucial role in determining the usage of foreign contracts.  

Differences Between Forward Contracts and Future Contracts

Even though at a glance it might sound the same, however, there is a considerable difference between the two of them. Like forward contracts, futures contracts are also a type of derivative, but they don’t seem to be identical to one another.  

Forward Contracts

Forward contracts are privately negotiated between two parties for trading an asset in the future at a given price. They trade and exchange on much more flexible terms and conditions like underlying assets delivery. Forward contracts often look “forward” to one date of settlement: the day the contract ends.  

There are several hedgers who use forward contracts. They use it to reduce any sort of potential volatility of the price of an asset. As the terms get set and executed, forward contracts often don’t tend to fall prone to price fluctuations.  

Forward contracts might not be your readily available option to your retail investors. This is because forward contracts are often unpredictable. These agreements are primarily kept between the buyers and sellers and are not publicized in any way. Since forward contracts are private agreements, you might even get prone to a counterparty risk as well. This means that one party might even act in default.  

Future Contracts

Like their forward contract counterparts, future contracts also play a crucial role in buying and selling an asset that specifies a proper price at a given date. These contracts are marked daily on the market where the daily changes get easily settled until the end of the contract. Also, remember that the future market is extremely liquid and hence they come up with methods to provide investors with the ability to make an entry or exit whenever they want. 

Future contracts are often used by speculators to look for profit from the asset’s move in price. In this case, speculators typically like to close their contracts right before maturity. For such circumstances, a cash settlement is hence proven ideal.  

Comparative Analysis of Future and Forward Contracts

Future contracts are primarily overseen by the US Commodity Futures Trading Commission and the Financial Industry Regulatory Authority. These help out with individual exchanges, brokerage, and clearinghouses. These ensure that the markets are running in an efficient manner and thus protect the investors from fraud and consumers from any sort of market manipulation.  

Risks of Forward Contracts

Forward contracts are not always seamless and having a forward contract transaction doesn’t always seem to be hunky-dory. Since the market of forward contracts is huge, large corporations primarily use it to hedge currencies and take interest rate risks. However, sometimes the details of forward contracts are often restricted from the buyers and sellers, it becomes difficult to estimate the market size.  

The large-size market is generally unregulated in the nature of the forward contracts. This means it is majorly susceptible to cascading through a series of worst-case scenarios. While banks and other financial institutions mitigate these risks by making careful choices, sometimes it can also be possible that large-scale defaults don’t exist in any way.  

Another important risk is that it arises from the non-standard natures of forward contracts where there is only one settlement date and hence they’re not marked by future markets.  

Final Thoughts

And that’s a wrap! That’s all you had to know in detail about forward contracts.  

We hope this blog was informative and helpful. Is there anything we missed out on? Let us know!  

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