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 specified 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 in 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.
- 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 maturation/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: This is the underlying asset that is specified in the contract.
- Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
- 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 on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.
Forwards are not traded on centralized exchanges. Instead, they are customized, over the counter contracts that are created between two parties. On 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. They enable the participants to lock in a price in the future. This guaranteed price can be very important, especially in industries that commonly 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 oil prices. Forwards are also commonly used to hedge against changes in currency exchange rates when making large international purchases.
Forward contracts can also be used purely for speculative purposes. This is less common than using futures since forwards are created by two parties and not available for trading 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 forward position. If the future spot price is greater than the agreed-upon contract price, they will profit.
What is the Difference Between a Forward Agreement and a Futures Contract?
Forwards and futures contracts are very similar. They both involve an agreement on a specific price and quantity 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 there is with futures contracts that have clearing houses.
- Forwards are settled on a single date, the expiration date, while futures are marked-to-market daily, meaning they can be traded at any time the exchange is open.
- 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 much more common for futures.
Forward Contract Payoff Diagram and 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, 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 forward to deal with foreign exchange rates. Your money is currently in US dollars. However, in one year’s time, you need to make a purchase in British pounds of €100,000. The spot exchange rate today is 1.13 US$/€, but you don’t want cash tied up in foreign currency for a year.
You do want to guarantee the exchange rate one year from now, so you enter into a forward deal for €100,000 at 1.13 US$/€. At the date of maturity, the spot exchange rate is 1.16 US$/€. How much money have you saved by entering into the forward agreement?
The 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 saved: $116,000 – $113,000 = $3,000.
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