An agreement between two agents to buy or sell a commodity or financial instrument at a predetermined price at a specified time in the future.
A forward contract is an agreement between two agents to buy or sell a commodity or financial instrument at a predetermined price at a specified time in the future.
Investors often use these contracts, especially in commodities or foreign exchange markets, to hedge against future price fluctuations.
These contracts are private agreements between two parties. They can be customized based on the asset to be traded (they are derivative instruments!), expiry date, and amount to be traded.
This means that they can differ between trades and are hence non-standardized. Due to this reason, such contracts can be hard to resell.
These contracts also cannot be sold through an organized exchange, making them over-the-counter (OTC) instruments.
The absence of a centralized agency can leave these contracts exposed to a higher risk of default relative to other financial instruments.
It is important to note that neither party is required to make any payment when a forward contract is agreed to.
It is only once the contract is executed that any transaction occurs. Hence, the buyer can benefit from a rise in prices while the seller can benefit from a fall in prices.
Like many other derivatives, in addition to hedging risk, these contracts can be used to speculate prices or allow either party to benefit from the time-sensitive underlying asset.
A few different types are available in the financial markets.
- Flexible: The investor has the option of exchanging funds before the date of settlement. The parties may exchange the funds or spread out payments before the settlement date.
- Options: Similar to flexible forward contracts, the investor can buy or sell the underlying asset within a given period at any date.
- Closed Outright: These are the simplest form. Both parties agree to a transaction for a specified amount at a pre-arranged future date.
- Non-Deliverable: There is no physical exchange of assets that takes place. Instead, the difference between the contract rate and the market rate is exchanged in the form of cash on the date of the settlement.
- Long-Dated: The maturity date for these contracts is much longer than that of most forwards. A standard forward can mature as quickly as three months. However, long-dated forwards may last for up to 10 years.
- Fixed-Dated: The maturity date of such contracts is fixed and cannot be altered.
- Window: The investor agrees to buy a fixed amount of the asset within a range of settlement dates. This enables the investor to obtain a more advantageous rate than they would obtain by using a typical forward contract.
Forward vs. Future Contracts
Both forward and futures contracts are agreements between two parties to exchange an asset for a predetermined price at a future date. However, despite their similarities, they are two different types of derivatives.
The table below provides an overview of the main differences between the two contracts.
|As discussed previously, these are not traded through exchanges.||Futures are forwards that have been standardized and are sold via an exchange.|
|They can be customized to fit the investor's needs and do not require any initial payment.||They are standardized and cannot be altered to suit the investor. Therefore, an initial marginal payment is required.|
|The buyer and seller can negotiate the price.||Investors quote the price, and the trade takes place on an exchange. There is no room for negotiation.|
|They are not regulated.||They are regulated by the Commodity Futures Trading Commission or CFTC.|
|Typically, the delivery of the asset marks the end of a forward contract.||The delivery of the asset does not necessarily signal the maturity of a future contract.|
|Counterparty risk is high, i.e., the probability that either side of the party may default on the contract is high.||Counterparty risk is low.|
|There is no guarantee of the settlement up until the date of maturity.||The initial margin deposited serves as a guarantee of the settlement.|
|They are traded on both primary and secondary markets.||They are traded only on the primary market.|
To better understand this contract, let us look at the following example.
Suppose a farmer wishes to sell 100,000 cassavas six months from now. However, she is concerned that the price of cassava will fall within this period.
To hedge against the risk of a potential price decline, the farmer can enter into a forward contract with her financial institution.
Let us assume she agrees to sell 100,000 cassavas to her bank for $50,000. There are now three possible outcomes for the future price of cassava:
1. The price is exactly $0.5 per cassava, and neither the farmer nor the bank owes each other any money. The contract is closed.
2. There is an excess supply of cassavas, and the 100,000 cassavas are worth only $40,000.
However, the bank has agreed to buy the product for $50,000 from the farmer.
Then, if the settlement is to be made in cash, the bank will give $10,000 to the farmer (this is the difference between the contract price of $50,000 and the market price of $40,000).
The farmer then sells her cassavas in the market to obtain the rest of the $40,000 and earns a total of $50,000.
3. Conversely, there may be an excess demand for cassavas such that the 100,000 cassavas are now worth $60,000. In this case, the farmer has to pay $10,000 to the bank.
Pros and Cons
As with all financial instruments, such contracts also have pros and cons.
Following are some of the advantages of these derivatives:
- First, they can help hedge currency and interest rate risks. Some of the world's largest corporations use forwards to hedge, making the market for these contracts massive.
- They are flexible and can be tailored to meet the needs of the transacting parties.
- As shown in the example in the previous section, they can be used to predict cash flows.
- They can be helpful when planning investments because businesses can choose to lock in funds (in any currency) and earn an income before the money is needed for the contract.
Following are some of the disadvantages:
- Due to their large size and lack of regulation, they are highly susceptible to the risk of default. Although banks and other financial corporations can mitigate this risk by choosing a credible counterparty, the possibility of default persists.
- Prices may move in any direction. If the prices move against either party, they lose and are required to pay the difference in the market price in the future.
- These types of contracts are far more complex than standard contracts.
Individual Investors and Derivative Contracts
In the real world, it is much easier for individual investors, such as yourself, to trade in future contracts.
This is because future contracts are standardized and can be traded through exchanges such as the New York Mercantile Exchange (NYMEX) or the Chicago Board of Trade (CBoT).
Of course, individual investors cannot directly trade on a securities exchange. For this reason, the transactions are taken care of by brokers.
Charles Schwab, TD Ameritrade, and Fidelity are a few of the several platforms available for trading futures.
Their ease of transaction makes futures a better alternative to forwards. Hence, most individual investors do not need to trade forward contracts.
Commercial banks often sell forward contracts to companies that want to control any fluctuations in currency and interest rates. Some companies may even use these derivative instruments for hedging purposes.
Recapitulating forwards is more suitable for giant enterprises, whereas future contracts serve as a tool for individual investors to speculate prices and potentially make a profit.
As mentioned previously, these are often used to mitigate currency risk.
Another means through which companies can protect themselves from such risks is by keeping a balance in a foreign currency that will be needed for expenditure in the future.
Such foreign currency accounts are similar to a typical bank account. The only difference is that a foreign currency account allows the account holder to send and receive money in currencies other than the domestic legal tender.
These accounts are especially beneficial for companies or individuals involved in many international transactions due to their ease of use and convenience.
However, this means the company must set aside this foreign currency in a bank account until it is needed to make the desired purchase.
Most businesses lack the necessary working capital, especially since hefty fees are involved in keeping a bank account open.
Further, domestic banks cannot always be used to open an account denominated in foreign currencies.
Opening a bank account in a new country for currencies that are not available domestically can also be quite expensive and challenging.
Opening a multi-currency account can be helpful for the company in such situations. These accounts allow businesses to hold different currencies and generally charge lower fees than regular banks.
- Forward contracts are agreements between two parties to trade an asset at a predetermined price at a specified time.
- They are a type of derivative instrument.
- Futures are different from forwards because they are standardized and regulated, making them easier to trade.
- Due to their ease of transaction, futures are a better option for individual investors than forwards.
- They are often used to hedge currency and interest rate risks, protecting the agent from fluctuations in price.
- However, they are highly vulnerable to default risk.
- Another alternative to these contracts is opening a multi-currency account to protect a company from currency risk.