1. Uses of Future Contracts
2. How Does a Forward Contract Work?
3. What Are the Risks Involved?

How do forward contracts work? They are a means of obligating the buyer to buy and the seller to sell. While no cash necessarily changes hands at the onset, a forward contract is essentially locking in that agreement between the involved parties.

A forward contract is quite similar to a futures contract, although they are not defined on standardized assets, such as market to market or exchange traded. Unlike a futures contract, a forward contracts terms can be negotiated and customized to best fit the needs and expectations of the involved parties; this is considered trading over the counter.

With that said, a future contract can, in turn, be more difficult to reverse, as all parties must be in agreement to the cancellation of the contract, or a third party must then get involved, agreeing to take over the counterparty’s responsibility.

The commonly traded assets in a forward contract include such commodities as:

  • Grain
  • Precious metals
  • Electricity
  • Beef
  • Natural gas
  • Foreign currencies

Uses of Future Contracts

Forward contracts are a way of locking in a set sale price between the buyer and seller. Corporate treasurers and Chief Financial Officers generally like forward contracts, as the ability to lock in things like interest rates and prices for goods or services can provide ease in determining future profit margins and ongoing cash flow.

Additionally, using future contracts can help alleviate concerns over market and pricing fluctuations. For example, the owner of a grape vineyard may enter into a forward contract with a wine manufacturer, as it helps them to always know what they will be earning. The wine maker benefits as well, as they have a locked in price for the grapes they are purchasing, regardless of what the vineyard may do with their pricing for other customers.

How Does a Forward Contract Work?

The logistics of a forward contract are pretty straightforward. Two parties enter into a contractual agreement, stating that by or on a certain date, a particular deliverable will be met by one party and the other party will provide payment. The payment will have already been agreed upon by all parties and be a part of the contract. For example, Company A will provide 10 bushels of apples to Company B on October 19, at which point, Company B will pay $200 for the bushels.

Sometimes people or businesses may find themselves in a cash settled situation regarding their forward contracts. This is essentially when one party makes out better than the other, due to changes in the market after such time as the contract was entered into. For example, at the time the contract was made, perhaps $200 was the going rate for 10 bushels of apples, but by the due date of October 19, the value of 10 bushels went up to $300.

In this case, the buyer has basically won out, as they are now buying their apples, per the conditions for the forward contract, for less than market value. The buyer’s gain is ultimately the seller’s loss, however, as they are now having to sell that particular buyer the apples for less than what they could make on the open market.

The temptation may be to then tell the buyer that the price has now gone up from $200 to $300, however that would be viewed as a breach of contract; even though future contracts are fairly simple and straightforward, they are still legally binding documents, holding all parties responsible for adhering to their respective ends of the deal.

What Are the Risks Involved?

As with anything in business, there are going to be potential risks involved and future contracts are no exception. One of the biggest one can end up being credit worthiness on the part of the buyer, as money does not exchange hands upfront. As the seller, there is the potential of finding yourself in the position of providing the deliverable on the agreed upon due date, only to find out that your buyer does not have the means to pay you. As a future contract is still, in fact, a contract, you can take legal action by suing the buyer for breach of contract; you also have the option of taking back whatever you were selling, and finding another buyer.

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