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.
A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging
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.
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.
Understanding Forward Contracts
Unlike standard futures contracts, a forward contract can be customized to a commodity, amount, and delivery date. Commodities traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.
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.
Forward Contracts vs. Futures Contracts
Both forward and futures contracts involve the agreement to buy or sell a commodity at a set price in the future. But there are slight differences between the two. While a forward contract does not trade on an exchange, a futures contract does.
Settlement for the forward contract takes place at the end of the contract, while the futures contract settles on a daily basis. Most importantly, futures contracts exist as standardized contracts that are not customized between counterparties.
Example of a Forward Contract
Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.
In six months, the spot price of corn has three possibilities:
It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.
Risks of Forward Contracts
The market for forward contracts is huge since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller—and are not known to the general public—the size of this market is difficult to estimate.
The large size and unregulated nature of the forward contracts market mean that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.
Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date and are not marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement?
In this case, the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.
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¶ TREASURY RATES💸
91 – Day Discount Rate 17.1150% Interest Rate 17.8800%
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1 Year Fixed Note Interest Rate 16.5672%
2 Year Fixed Note Interest Rate 21.5000%
3 Year Bond Interest Rate 20.8500%
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💧MUTUAL FUNDS IN GHANA♣️
📈EQUITY FUNDS ➰YTD%
Databank EPAcK 🔼+4.83%
Republic Equity Trust 🔼+2.08%
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⚖BALANCED FUNDS ⏸ YTD%
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CDH Balanced Fund 🔼+3.06%
Fidelity Balanced Trust 🔼+4.29%
CM Fund 🔼+3.94%
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Plus Balanced Fund 🔼+6.31%
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Republic Future Plan Trust 🔼+2.87%
UMB Balanced Fund 🔼+3.46%
Databank EdiFund Tier 2 🔼+4.43%
⚙FIXED INCOME FUNDS 🛡YTD%
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Fidelity Fixed Income Trust 🔼+5.18%
Financial Independence Fund 🔼+4.97%
Fixed Income Alpha Plus 🔼+5.96%
Nimed Fixed Income Fund Tier 1 🔼+4.94%
Nimed Fixed Income Fund Tier 2 🔼+5.41%
Plus Income Fund 🔼+6.11%
STANLIB Income Fund Trust 🔼+5.97%
Databank EdiFund T1 🔼+5.84%
MONEY MARKET FUNDS ⏱YTD%
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Octane DC Money Market Fund 🔼+4.79%
First Fund 🔼+4.18%
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