Forward Contracts: Everything You Need to Know
Forward contracts are agreements created between two individuals or businesses that govern the buying and selling of any asset or commodity at a set time in the future for a set price.3 min read
2. Understanding a Forward Contract
3. Forward Contract Markets
4. Why Use a Forward Contract?
Forward contracts are agreements created between two individuals or businesses that govern the buying and selling of any asset or commodity at a set time in the future for a set price.
What Is a Forward Contract?
Forward contracts are commonly used for the following types of products:
- Precious metals and stones
- Natural gas
- Orange juice
These commodities are frequently bought and sold internationally, so foreign currency is a big part of the current forward market.
Forward contracts are useful for both speculation and hedging, but they are especially good for hedging in the global market. This means that they can be used to manage what specific commodities can be bought and sold for. If one country has a forward contract with another governing the sale of a certain spice, the price of that spice is locked in. This helps keep the global market under control.
A forward contract is similar to a futures contract but differs because of its flexibility. Forward contracts can be used for any type of product, for any amount of money, to be traded at any future time. Futures contracts are standardized.
The settlement of the contract can happen through delivery or cash.
Because forward contracts are not a part of a centralized exchange, they are called OTC instruments or over-the-counter. This OTC aspect of forward contracts makes them flexible and customizable but can also make them riskier than an agreement governed by a centralized exchange.
Retail investors are more likely to use futures contracts rather than forward contracts.
Understanding a Forward Contract
To understand how a forward contract works, consider the following scenario.
An orchard owner has one million bushels of apples that he wants to sell once they are fully grown and ripened in about four months. He doesn't know how the price of apples might change over that time period, so he wants to lock in a price now. He can form a forward contract with a buyer that stipulates that the buyer will purchase that one million bushels of apples at $5.10 per bushel four months from the date of the contract. The contract will outline the terms and settlement.
The result of this forward contract has some possibilities for the spot price of apples. First, the cost of apples could stay right at $5.10 per bushel, and the orchard owner and the buyer are both happy; the contract is completed. If the cost ends up higher in four months, maybe at $6 per bushel, then the seller owes the buyer the difference between one million apples at $6 a bushel and $5.10 a bushel. If the cost declines, the buyer owes the seller the difference.
Forward Contract Markets
Many big companies use forward contracts to control changes in currency and interest rates or for hedging. It's tough to determine the actual size of the market for forward contracts because the contracts are not standardized and are therefore kept confidential between the buyers and sellers.
Because forward contracts are so flexible and widely used, they can be subjected to many defaults if they fall through or run into any legal issues.
Why Use a Forward Contract?
There are many benefits to forward contracts. They allow the parties involved to set prices for the sale or purchasing of products without upfront costs. This makes forward contracts appealing to the treasures of major corporations because they can better control and prepare for their company's projected profits and losses.
With a forward contract, businesses can lock in the following pieces before the trade actually takes place:
- Profit margins
- Interest rates
- Cash planning assistance
- Resource supplying
Businesses like banks and corporations can try to better control pricing risks with the use of forward contracts. This can be beneficial to both the buyer and seller.
For example, a major coffee company can lock in prices for coffee beans from their suppliers and therefore be able to better project how much profit the company will make on their sales. The supplier can also benefit from knowing exactly how much they'll make on each pound they sell. The coffee company can avoid having to suddenly change prices on their customers or take unexpected losses because of a change in prices for beans. If a change does need to happen, they'll have time to gradually adjust their sales in order to prevent loss.
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