Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Forward Contract

What it is:

A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time.

The assets often traded in forward contracts include commodities like grain, precious metals, electricity, oil, beef, orange juice, and natural gas, but foreign currencies and financial instruments are also part of today's forward markets.

How it works (Example):

If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on the market price when you take delivery of the wheat.

Forward Contracts Are Not the Same as Futures Contracts

Futures and forwards both allow people to buy or sell an asset at a specific time at a given price, but forward contracts are not standardized or traded on an exchange. They are private agreements with terms that may vary from contract to contract.

Also, settlement occurs at the end of a forward contract. Futures contracts settle every day, meaning that both parties must have the money to ride the fluctuations in price over the life of the contract.

The parties to a forward contract tend to bear more credit risk than the parties to futures contracts because there is no clearinghouse involved that guarantees performance. Thus, there is always a chance that a party to a forward contract will default, and the harmed party's only recourse may be to sue. As a result, forward-contract prices often include premiums for the added credit risk.

Valuing Forward Contracts

The value of a forward contract usually changes when the value of the underlying asset changes. So if the contract requires the buyer to pay $1,000 for 500 bushels of wheat but the market price drops to $600 for 500 bushels of wheat, the contract is worth $400 to the seller (because he or she would get $400 more than the market price for his or her wheat). Forward contracts are a zero-sum game; that is, if one side makes a million dollars, the other side loses a million dollars.

Forward contracts may be "cash settled," meaning that they settle with a single payment for the value of the forward contract. For example, if the price of 500 bushels of wheat is $1,000 in the spot market (the current market price) when the forward contract expires, but the forward contract requires the buyer to pay only $800, then the seller can just settle the contract by paying the buyer $200 instead of actually delivering 500 bushels of wheat and collecting a below-market price. The buyer might appreciate this; the only other way he would see his $200 profit is if he purchased the wheat for $800 and then turned around and sold it at the market price ($1,000). On a side note, when the spot price is higher than the forward-contract price, this is called backwardation; the opposite condition is called contango.

It is important to note that forward contracts also present a risk of price manipulation, because a small transaction completed at an above- or below-market price could affect the value of a much larger forward contract.
 

Why it Matters:

There are two kinds of forward-contract participants: hedgers and speculators. Hedgers do not usually seek a profit but rather seek to stabilize the revenues or costs of their business operations. Their gains or losses are usually offset to some degree by a corresponding loss or gain in the market for the underlying asset. Speculators are usually not interested in taking possession of the underlying assets. They essentially place bets on which way prices will go. Forward contracts tend to attract more hedgers than speculators.