A forward commitment refers to a contractual agreement between two parties to carry out a planned transaction, i.e., a transaction in the future. Forward commitments differ in terms of their structure and the exact contracting mechanism. Some common forward commitments are forward contracts, futures contracts, and swaps.
How They Work
When two parties intend to enter into or settle a transaction in the future, they enter either explicitly or implicitly into a forward commitment. The underlying principle driving all forward commitments is the transacting parties’ desire to mediate the level of risk associated with the transaction to be carried out.
Forward commitments are required to exclusively specify the transaction in consideration and all details involved with the same, including the good or service being purchased and sold, price, metric quantities, payment method, payment date, delivery method, delivery date, etc. Forward commitments are tradable in the form of contracts on the exchange markets or through over the counter (OTC) markets.
Types of Forward Commitments
Forward commitments differ in terms of their structure and the exact contracting mechanism. They include forward contracts, futures contracts, and swaps.
1. Forward contract
A forward contract is non-traded and is more of an arrangement between two transacting parties. It specifies the identity of both the buyer the seller, the transaction price (or prices), and the transaction date.
2. Futures contract
A futures contract is very similar to a forwards contract except that the former can be traded on an organized exchange. A futures contract also specifies the identity of both the buyer the seller, the transaction price (or prices), and the transaction date. However, the vast majority of transactions in the futures markets involve parties with no intention of ever completing the transaction (i.e., ever taking delivery of the good).
A swap is a type of forward commitment that is entered into by parties who agree to exchange recurring transactions, a series of forward contracts, or future cash flows. It is customizable to accommodate the requirements of the transacting parties with respect to the kind of transaction involved. Swaps are not tradable, as they are off the counter, private contracts/agreements.
Advantages of Forward Commitments
Forward commitments offer the following advantages:
Forward commitments come with the benefit of certainty and security of carrying out a transaction. They are required to exclusively specify all details of the planned transaction. Since every detail pertaining to the future is already agreed upon in the present, a sense of security and certainty are achieved, and all speculations regarding unforeseen events or uncertainty are eliminated from the transaction.
2. Cost benefits
Forward commitments enable the parties involved to lock in the current interest rates to be transacted in at a future date. It provides a crucial cost benefit to the parties involved as the factors of speculation and uncertainty involved with future exchange and interest rates are eliminated, and hence, so is the possibility of price volatility in the future.
When transactions are agreed upon in the future, it gives a sense of security to both the seller and the buyer. The seller is certain of the fact that he will receive a payment at a specific future date, and the buyer receives security in being aware of a payment to be made in the future. The buyer also receives enough time to arrange the funds for a transaction that is certain to happen in the future.
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