Forward Contract

What is a Forward Contract?

A forward contract, commonly known as a forward, is a customizable over-the-counter (OTC) derivative contract between two parties who agree to exchange an asset at an agreed upon price on the contract settlement (expiration) date. 

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

At expiration, forward contracts can be settled in cash or by physical delivery of the asset. They can be used as a speculative bet or to hedge a current position from potential losses.

Since forwards are private contracts and aren't traded over exchanges, the price, settlement date, quantity, and asset type can be fully customized by both parties. The price agreed upon is known as the delivery price which is calculated based on the existing market prices adjusted for the expected price movement of the asset and the time value of money factor.

These contracts are typically used by large institutions and aren't available to retail investors. They are typically used for commodities such as oil, grains, and livestock; interest rates, and currencies.

There are two sides, or positions, to a forward contract. When a company wants to buy an asset in the future, they will enter into a long position, and be long the forward contract. When a company wants to receive money in exchange for selling an asset in the future, they will enter into a short position, and be short the forward. 

How Does a Forward Contract Work?

Let's assume John would like to purchase a used car in six months, and Jane would like to sell her car for $20,000 six months from now. John doesn't have enough money right now, but he expects the price of used cars to increase over the next six months and would like to lock in a price today. John meets with Jane and they both agree on a sale price of $21,000 six months from now. In six months, John agrees to give Jane $21,000 and Jane agrees to deliver the car to John.

Let's now assume today is the settlement date, or six months from the day John and Jane entered into the forward agreement, and used car prices have increased. Jane's car is now worth $25,000. John and Jane meet up and make the exchange. John gives Jane $21,000 and Jane gives him the car. Even though the price of Jane's car is worth $25,000 today, John only needs to pay her $21,000 because that was the agreed upon price, and they are both contractually obligated to follow the terms set forth in the contract. Since Jane could have sold her car for $25,000 today, she incurs a loss of $4,000 ($21,000 - $25,000). John has gained $4,000 ($25,000 - $21,000) because he only paid $21,000 for a car that is worth $25,000 today. 

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

When To Enter Into a Forward Contract 

An institution would enter into a forward contract if it wants to customize the terms of the contract, for example a similar contract isn't available on a centralized exchange in the futures market, and believes the asset may experience adverse (prompting a hedged position) or favorable price movements (potentially prompting a speculative bet).

Buying a Forward Contract

A trader can use a forward to hedge a current short position in an asset by buying a forward contract to lock in a cheaper price today if they believe the price of the underlying asset will increase up to expiration. 

If the price increases and the short position is not covered, the trader will suffer significant losses on the position. However, if they had entered into a forward contract well in advance to cover the position, on the expiration date, they would have bought the asset at the settlement price, i.e. agreed upon price, and the gain on the same would have been offset against the loss on the short position effectively leading to no gain nor any losses. 

On the other hand, if the price of the underlying asset reduces in value before the expiration date, the trader would make a profit on the short position and a loss on the long forward position, which again leads to offsetting profit and losses on both positions.

Hence, buying forward contracts leads to a long position on the underlying asset and is a good way to hedge against the effects of price movements on a short position in the underlying assets.

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

If an institution, such as a hedge fund, believes the price of an asset, such as oil, will increase significantly in the future, it can make a speculative bet by buying a forward contract to lock in a cheaper price today; and then realize the profits by selling the asset at a premium after the contract is settled. If the price moves in the opposite direction however, the fund will incur heavy losses as they would have to buy the asset at the forward prices which would be higher than the spot price.

Selling a Forward Contract

Similar to other derivative products, if there is a buyer, there must also be a seller; however, unlike other derivative products, the seller in a forward is known at the time of contract initiation.

A trader can also use a forward to hedge a long position in an asset by selling a contract to lock in a higher price today if they believe the price of the underlying asset will decrease up to expiration.

If the price decreases and the long position is not covered, the trader will suffer significant losses on the position. 

However, if they had covered the position in advance, they would have sold the asset at the settlement price, i.e. agreed upon price, on the expiration date and the gain on the contract would have been offset against the loss on the long position effectively leading to no gain nor loss.

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

On the other hand, if the price of the underlying asset increases in value before the expiration date, the trader would make a profit on the long position and incur a loss on the short position, which again leads to offsetting profit and losses on both positions.

Hence, selling forward contracts leads to a short position on the underlying asset and is a good way to hedge against the effects of price movements on a long position in the underlying assets.

If an institution, such as an oil company, believes the price of a barrel of oil will fall in the future, it can sell a forward contract to set up a hedge and lock in the higher price today.. At expiration, the oil company will deliver the barrels of oil at the agreed upon price. If the price of an oil barrel is less than the settlement price, the hedge was successful.

Price Of A Forward Contract: Spot-Forward Parity

The price of a forward contract is related to the spot-forward parity, which is the relationship between the spot and forward price of the underlying asset. The spot-forward parity states that the value of the forward contract on the settlement date should equal the current spot price after adjusting for the cost of carry (costs and benefits of holding the underlying asset). The cost of carry is composed of:

  • Storage cost if the underlying asset is a physical asset (oil has a negative cost of carry).

  • Convenience yield depending on the current supply and demand of the underlying asset. Income if the underlying asset generates interest or dividends (bonds will have a positive cost of carry).The value of the forward contract will be equal to the spot price less any costs (storage costs and convenience yield) plus any benefits (interest or dividends).

Underlying assets in a forward contract can be categorized as an investment asset (an asset that generates income such as stocks and bonds) or a consumption asset (an asset that will be used in the future such as oil and pigs). Investment assets will generally have a positive cost of carry because stocks may pay dividends, while bonds pay interest. Consumption assets will generally have a negative cost of carry because these assets will incur storage costs.

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

Contango vs. Backwardation

Contango and backwardation refer to the shape of the forward curve beginning today out into the future. The price today would be considered the spot price and the price in the future is called the forward price. 

If the forward curve is in contango, the spot price (price today) is greater than the forward price (price in the future). This means the payoff for the short position, or seller, will be positive. To better understand this let's assume Joe wants to sell a pair of shoes one year from today. He looks at the forward curve and sees that the spot price (price today) is $60 and the forward price one year from now is $18. He decides to enter into a short position in a forward contract to sell one pair of shoes for $60 one year from today. If this relationship holds until the end of the contract, that the future price of $18 one year from now is the spot price, or the price today, then Joe's position will experience a profit of $42 ($60 - $18). 

Below is a chart illustrating this example.

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

If the forward curve is in backwardation, the spot price (price today) is less than the forward price (price in the future). This means the payoff for the long position, or buyer, will be positive. 

To better understand this let's assume Emily wants to buy a pair of shoes one year from today. She looks at the forward curve and sees that the spot price (price today) is $60 and the forward price one year from now is $100. She decides to enter into a long position in a forward contract to buy one pair of shoes for $60 one year from today. 

If this relationship holds until the end of the contract, that the future price of $100 one year from now is the spot price, or the price today, then her position will experience a profit of $40 ($100 - $60). 

Below is a chart illustrating this example.

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

Risk and Benefits of Forward Contracts

Forwards are used for hedging and speculation and as with every investment class, it goes without saying that they pose a unique set of risks and benefits for investors. We walk you through each of them briefly below.

Risks Of Using Forwards

Since forwards are private over-the-counter derivatives that aren't traded on exchanges, they carry several risks over and above that of other derivative products such as futures or options. Here are some of the risks involved with entering into this type of contract:

  • Depending on the terms, it may be difficult to find another party to enter into the opposite side of the contract, for instance if an institution is buying a forward, it may be difficult to find a seller.

  • Unfavorable pricing if there is a lack of availability of a forward with the desired terms.

  • Counterparty risk since forwards are only settled on the settlement date. One party must deliver the asset (the seller) and one must buy the asset (the buyer). If one party cannot fulfill their contractual obligation, then that party will default leaving one part without the physical asset or cash. 

 

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

Benefits Of Forwards

Because forwards aren't standardized or traded on exchanges, they offer several benefits, which are listed below:

  • Terms can be customized: asset type, settlement date, value, and quantity can be fully customized between both parties.

  • Lock in a favorable price, which can be used as a hedge.

  • The underlying asset can vary, for instance  currencies, interest rates, and commodities.

  • Can be used to structure a perfectly hedged position.

Payoff Formula Of A Forward Contract

The payoff on a forward contract is the difference between the spot price and forward price. It assumes that the contract will be settled by cash and not delivery. If the spot price is more than the contract price, the party that is long the contract will profit and receive a payoff from the party that is short and vice versa. We illustrate the formula to calculate the payoff for both the long and short position below.

For both scenarios, we will use:

  • ST as the spot price, which is the spot price at expiration.

  • F0 as the forward price, which is the agreed upon price at expiration.

 

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

Payoff For A Buyer Of A Forward (Long Position)

On the settlement date, if the spot price is greater than the forward price, the buyer of the forward profits while if the spot price is less than the forward price, the buyer will experience a loss. Payoff at expiration can be calculated as:

 

Payoff for a Buyer = ST - F0

Payoff For A Seller Of A Forward (Short Position)

On the settlement date, if the spot price is less than the forward price, the seller of the forward profits while if the spot price is greater than the forward price, the seller will experience a loss.

 

Payoff for a Seller = F0 - ST

Example Of A Forward Contract

Let's assume an oil-producing company would like to sell 100,000 barrels of oil at $60 a barrel over the next four months and believes that there will be a shock in the oil market, moving the price per barrel below $60 over the same period. In order to hedge its position and lock in a price of $60 a barrel, it decides to look into the forwards and futures markets. After contacting several futures exchanges, the company discovers that both the number of barrels per contract and the settlement dates don't align with what is desired. 

It then decides to enter into a forward contract with a gas company that believes the price of oil will finish above $60 a barrel four months from now (the gas company will be long on the contract, and by extension the asset).

On the settlement date, the oil producer will deliver 100,000 barrels of oil at $60/barrel no matter what the spot price is on the settlement date; however, the gain and loss will depend on the spot price. Please note the payoffs below are from the perspective of a seller of a forward contract:

If the price per barrel is $70, the loss to the oil producer is $10 per barrel, or $1,000,000 (60 * 100,000 - 70 * 100,000).

If the price per barrel is $60, both parties will be breakeven (60 * 100,000 - 60 * 100,000).

If the price per barrel is $50/barrel, the gain to the oil producer is $10 per barrel, or $1,000,000 (60 * 100,000 - 50 * 100,000).

Forwards vs. Futures

Forwards and futures are similar due to the fact that they both involve an agreement between two parties to exchange an underlying asset at an agreed upon price. However, there are several differences between them, which we have tabulated below:

 

 

  Forwards

 

                  Futures

Traded over-the-counter and privately held

Traded over an exchange

Customizable

Standardized (not customizable)

Counterparty risk

Guaranteed by an exchange (no counterparty risk)

Counterparty is known

Counterparty is unknown

No initial margin requirement

Requires initial margin at inception of contract

Only settled on settlement date

Settled daily (marked to market)

Physical delivery of underlying asset is common

Physical delivery of underlying asset isn't common

 

When choosing between forwards and futures, it comes down to the type of asset and its availability on futures exchanges. If the asset and terms of the contract can be found on an exchange, it would be easier and less risky to purchase futures contracts (forwards have counterparty risk, while futures are guaranteed by the futures exchange). 

wall-street-oasis_financial-industry-resources_web_online-financial-industry-master-courses.jpg

Forwards vs. Options

The main difference between a forward and an option is: forwards are private over-the-counter contracts where both parties have a contractual obligation to buy or deliver an asset, whereas an option gives the right, or option, to the buyer, to exercise the option if the price reaches a certain strike price, there are no contractual obligations. Tabulated below are a few more differences:

 

 

               Forwards

 

                Options

Traded over-the-counter and privately held

Traded over an exchange

Customizable

Standardized (not customizable)

Counterparty risk

Guaranteed by an exchange (no counterparty risk)

Counterparty is known

Counterparty is unknown

No initial margin requirement

 

Buyer of an option must pay a premium; seller receives a premium

 

Only settled on settlement date

Can be exercised at any time

Underlying assets: commodities such as oil, precious metals, and livestock

Underlying assets: stocks, bonds, and currencies

Accessible to large institutions

Accessible to everyone, including retail investors

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: