FORWARD CONTRACT

FORWARD CONTRACT

What is forward contract and what characteristics a forward contract has?

Forwards Contracts represent a legal agreement between two parties connecting a Buyer and a Seller of a specified asset at a specified price on a specific date in the future. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly suitable for hedging.

The forward contract is typically used to remove the volatility in the future price of the asset.

Main characteristics of a forward contract:

  • Forward contracts can be easily adjusted to a particular trading commodity. Also, contract can be tailored to a particular price and delivery date.
  • Another characteristic of a forward contract is that forward contract does not trade on a centralized exchange and is considered as over-the-counter (OTC) instrument. As a result of its possible of default risk and absence of a centralized clearinghouse, forward contracts are not accessible to retail investors.
  • Forward contracts can help producers and users of agricultural products hedge against a change in the price of an underlying asset or commodity.
  • Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk compared to contracts that are marked-to-market regularly.


What are the different types of forward contract?

Closed outright forward contract

Forward contract’s simplest type is also named “European,” “fixed” or “standard” contract. In this forward contract agreement parties are engaged to exchange funds on a stated date in the future.

Flexible forward contract

Flexible forward contract (FFC) is an FX contract that gives the opportunity to the person who entered into this legal contract to position the buy or sell rate of a currency pair at a specific time, between two closed dates, for a particular amount.

Long-Dated Forward

This type of forward contract is used in foreign currency trades with a predefined date longer than one year away and as far as 10 years. Long-Dated Forward contract will cover companies from avoiding any potential currency exposures.

As opposed to a short-dated forward contract with less length of up to one year.

Non-deliverable forward (NDF)

This type of forward contract is often short- term contract. The price that is theoretically settled is never be given. That’s is why they named it non-deliverable. Counterparties come to an opposite deal of a transaction for a set amount of money at a contracted rate, in the case of a currency NDF. The profit or loss is calculated on the theoretical amount of the contract by taking the difference between the agreed-upon rate and the spot rate at the time of settlement.


Are forward contracts traded on an exchange?

Forward contracts do not trade on a centralized exchange and are therefore regarded as over the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.


Advantages and disadvantages of a forward contract

Forward contracts can provide a more stable investment for traders of a chosen asset.

Nevertheless, derivatives are complex instruments with potential risks, so it is important to conduct research and take these into consideration. The unsteadiness of the market is an unavoidable part of an exchange, but forward contract can help block against possibly damaging price movements and changes, while also offering contracts that are private and adjusted to your personal needs. It is very simple to set it up, it provides you with security and privacy for both the buyer and seller and ensures you that there is less risk due to market volatility. Another advantage that is very important to consider when making a forward contract is the inexpensive maintain, low costs and you can get currency early after drawing down.

But the are some disadvantages when contacting a forward contract that you might need to know before. The main disadvantage when looking at currency risk protection is that somehow hedging can work against you. When the currency moves beneficially to you it means you have missed the gains. You must tie up your capital even if your deposit is small and also forward contract can lead you to lose more than your account balance. Forward contracts have a significant counterparty risk which is also the reason why they are not readily available to retail investors.


Forward contract vs Futures contract

Forward and future contracts involve the agreement to buy or sell a commodity at a set price in the future. But there are slight differences between these two contracts that you might didn’t know.

• Futures contracts are traded on an exchange

• Forward contracts are privately traded.

• Futures contracts are highly standardized since they are traded on the exchange.

• Forward contracts, on the other hand, are customized as per the requirements of the counterparties. A single clearinghouse acts as the counterparty for all futures contracts. This means that the clearinghouse is the buyer for every seller and the seller for every buyer. This eliminates the risk of default, and also allows traders to reverse their positions at a future date.

• Futures contracts require a margin to be posted at the contract initiation, which fluctuates as the futures prices fluctuate. There is no such margin requirement in a forward contract.

• The government regulates the futures market

• Forward market is not regulated.

• Forward contract compared to its futures counterpart is having no upfront cashflows. Specifically, when the forward contract is denominated in a foreign currency, not having to post (or receive) daily settlements simplifies cashflow management.


Example of a forward contract

Forward contracts have existed since at least Greek and Roman times. They commonly used during the Middle Ages in Europe, and Europeans continued the tradition of forward contracts in the New World.

Forward contracts were used to stockpile essential goods that could be resold for a profit at a later date. Buyers would take possession of the wheat, corn, or other commodities upon delivery of the contract, pay the forward price (agreed upon in the contract) and hope that the demand for the good would grow so they could raise prices, resell it, and generate profits.

Farmers today are facing the same more or less volatility regarding their price uncertainty each year. Their crops fail due to insects, disease, or weather, and the demand for their crops may fluctuate substantially.

If we assume that a farmer sells two million bushels of corn in a range of six months from now and is concerned about a potential decrease in the price of corn then a forward contract will be conducted with its financial institution to bring assurance to the farmer.

The forward contract will provide safety to the agricultural producer that he will sell his products in six months at the price of $4.30 each. He will lock to this position but if the spot price will changes in six months, then there are 3 consequences:

• It is exactly $4.30 per bushel. No profits to each of the parties and the contract is closed.

• It is higher than the contract price, say $5 per bushel. The farmer must give the difference between the current spot price and the contracted one.

• It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the farmer the difference between the contracted price and the current one.



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