What is a Forward Contract?
A forward contract, often shortened to just forward, is a contract agreement to buy or sell an asset at a specific price on a specific date in the future. Since the forward contract refers to the underlying asset that will be delivered on the specified date, it is considered a type of derivative.
Forward contracts can be used to lock into a specific price to avoid volatility in pricing. The party who buys a forward contract is entering into a long position, and the party selling a forward contract enters into a short position. If the price of the underlying asset increases, the long position benefits. If the underlying asset price decreases, the short position benefits.
Quick Summary of Points
- A forward contract is an agreement between two parties to trade a specific quantity of an asset for a pre-specified price at a specific date in the future.
- Forwards are very similar to futures; however, there are key differences.
- A forward long position benefits when on the expiration date, the underlying asset has risen in price, while a forward short position benefits when the underlying asset has fallen in price.
How do Forward Contracts Work?
Forward contracts have four main components to consider. The following are the four components:
- Asset Class: This is the underlying asset that will be specified in the contract.
- Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered.
- Quantity: This is the size of the contract, and will give the specific amount in units of the asset being bought and sold.
- Price: The price that will be paid at the expiration date must also be specified. This will also include the currency that will be used.
Forwards are not traded on centralized exchanges and are instead customized contracts that are created between two parties. At the expiration date, the contract must be settled. One party will deliver the underlying asset, while the other party will pay the agreed-upon price and take possession of the asset. Forwards can also be cash-settled at the date of expiration rather than delivering the physical underlying asset.
What are Forward Contracts Used For?
Forward contracts are mainly used to hedge against potential losses. These contracts allow the participant to lock into a price in the future. This guaranteed price can be very important especially in certain industries that experience significant volatility in prices. For example, in the oil industry, entering into a forward contract to sell a specific number of barrels of oil can be used to protect against potential downward swings in future oil prices. Forwards are also commonly used to hedge against changes in future currency exchange rates when making large international purchases.
Forward contracts can also be used for speculation purposes. This is less common than using futures since forwards are created by two parties and not available on centralized exchanges. If a speculator believes that the future spot price of an asset will be higher than the forward price today, they may enter into a long position using a forward contract. If the future spot price is greater than the agreed-upon contract price, they will profit.
What is the Difference Between a Forward Contract and a Futures Contract?
Forward and futures contracts are very similar. They both involve an agreement on a specific price of an underlying asset to be paid at a specified date in the future. There are however a few key differences:
- Forwards are customized, private contracts between two parties, while futures are standardized contracts that are traded on centralized exchanges.
- Forwards are settled at the expiration date between the two parties meaning there is higher counterparty risk than futures contracts that have clearing houses.
- Forwards are settled on a single date, the expiration date, while futures are marked-to-market daily meaning the difference in the underlying asset’s value is settled daily.
- Since forwards are settled on a single date, they are not commonly associated with initial margins or maintenance margins like futures contracts.
- Although both contracts can involve the delivery of the asset, or settlement in cash, physical delivery is more common for forwards while cash-settlement is more common for futures.
Forward Contract Payoff Diagram and Worked Example
The payoff of a forward contract is given by:
- Forward contract long position payoff: ST – K
- Forward contract short position payoff: K – ST
- K is the agreed-upon delivery price.
- ST is the spot price of the underlying asset at maturity.
Let us now look at what the payoff diagram of a forward contract is, based on the price of the underlying asset at maturity:
Here we can see what the payoff would be for both the long position and short position of a forward contract, where K is the agreed-upon price of the underlying asset, specified in the contract. The higher the price of the underlying asset at maturity, the greater the payoff for the long position. A price below K at maturity, however, would mean a loss for the long position. If the price of the underlying asset were to fall to 0, the long position payoff would be -K. The forward short position has the exact opposite payoff. If the price at maturity were to drop to 0, the short position would have a payoff of K.
Let us now consider an example question that uses a type of forward contract focused on an exchange rate. Your money is currently in US dollars however in one year’s time you need to make a purchase amounting to €100,000. The spot exchange rate today is 1.13 US$/€ however you don’t want cash tied up in foreign currency for a year. You want to guarantee this exchange rate in one year however so you enter into a forward contract for €100,000 at 1.13 US$/€. At the date of maturity, the spot price is now 1.16 US$/€. How much money have you saved by entering into this contract?
This contract is an agreement to pay $113,000 (calculated from €100,000 x 1.13 US$/€) for €100,000.
If you had not entered into the contract, at the maturity date you would have paid €100,000 x 1.16 US$/€ = $116,000
By hedging your position with a forward contract, you have saved: $116,000 – $113,000 = $3,000.
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