What exactly is a forward contract?
Customized forward contracts allow two parties to acquire or sell an item at a fixed price at a future date. Because of their non-standardized character, forward contracts are ideal for hedging rather than speculating.
Understanding Forward Contracts
Unlike regular futures contracts, forward contract customization allows for commodity, quantity, and delivery date customization. Traded commodities include cereals, precious metals, natural gas, oil, and poultry. Forward contract settlements might be cash or delivery.
Forward contracts are OTC because they trade without a central exchange. Although OTC conditions allow for customization, the absence of a centralized clearinghouse increases default risk.
With potential default risk and no central clearinghouse, forward contracts are less accessible to ordinary investors than futures contracts.
The Difference Between Forward and Futures Contracts
Forward and futures contracts entail buying or selling a commodity at a stated price in the future. But there are some distinctions. Futures contracts trade on exchanges, while forward contracts do not.
Forward contract settlement occurs at the contract end, whereas futures contract settlement occurs daily. Most significantly, futures contracts are standardized and not personalized between counterparties.
Example of Forward Contract
Consider this forward contract. Assume a farmer has two million bushels of grain to sell in six months and worries about a price drop. The company signed a forward agreement with its banking institution to sell 2 million bushels of maize for $4.30 per bushel for six months, with a cash settlement.
The spot price of corn has three options in six months:
- The Bushel price is $4.30.The contract is concluded since the producer and financial institution owe each other nothing.
- It exceeds the $5-per-bushel contract price. The producer owes the institution $1.4 million, the spot price less the $4.30 agreed rate.
- Lower than the contract price of $3.50 per bushel.The financial institution will pay the manufacturer $1.6 million, the difference between the $4.30 agreed rate and spot pricing.
Forward Contract Risks
This market is vast since major firms utilize it to hedge currency and interest rate risks. The extent of this market is hard to assess because advance contract terms are private and only known to buyers and sellers.
Due to its scale and unregulated nature, the forward contract market may see a cascade of defaults in the worst-case scenario. Despite rigorous counterparty selection, banks and financial firms face the danger of large-scale default.
Forward contracts, unlike futures, are non-standard and only settled on the settlement day, posing a risk. What happens if the contract’s forward rate differs significantly from the spot rate at settlement?
The financial institution that originated the forward contract has more risk in the event of default or non-settlement by the customer compared to a marked-to-market agreement.
- It is a customizable derivative contract between two parties to purchase or sell an item at a future price.
- It can specify the commodity, quantity, and delivery date.
- OTC forward contracts trade without a central exchange.
- It can help agricultural producers and users hedge against price changes.
- Financial institutions that initiate the contracts face more settlement and default risk than those with marked-to-market agreements.