What Is a Forward Contract?
A forward contract is a private agreement between two parties that simultaneously obligates the buyer to purchase an asset and the seller to sell the asset at a set price at a future point in time.
Unlike futures – which are regulated and monitored by the Commodities Futures Trading Commission (CFTC) – forward contracts are unregulated. Such unregulated financial instruments are called over-the-counter (OTC) instruments.
A Brief History of Forward Contracts
Forward contracts have existed since at least Greek and Roman times. There’s a great deal of evidence that they were commonly used during the Middle Ages in Europe, and the 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.
How Do Forward Contracts Work?
Forward contracts begin when a seller seeks a buyer for some commodity. Think of farmers who face considerable price uncertainty each year. Their crops fail due to insects, disease, or weather, and the demand for their crops may fluctuate substantially.
To protect against uncertainty, farmers may draw up a forward contract and sell it to a private buyer. For example, large food manufacturers may purchase a farmer's wheat forward contract to lock in the price and control their manufacturing cost. The farmer hopes to benefit from the forward contract by ensuring that he has a buyer for the commodity. He’ll also have an agreed-upon price if he can meet the forward contract's qualifications, like producing and delivering bushels of wheat, corn, or oats.
The buyer assumes a long position and the seller assumes a short position when the forward contract is executed. The agreed-upon price is called the delivery price. It is equal to the forward price at the time that the two parties enter into a contract.
Forward contracts attract two types of buyers: hedgers and speculators. Typically, more hedgers than speculators participate in forward contracts.
Hedgers enter into forward contracts to stabilize revenues or costs of their business operations. Instead of seeking profit, gains are used to offset losses in the market for an underlying asset.
Speculators try to maximize their profits by "betting" on which way the prices will go. They aren't interested in buying or selling the underlying asset. Instead, they hope to profit on the forward contract itself by "betting" on the direction the price will go.
Why Is a Forward Contract Useful?
Despite being a zero-sum transaction (where one party wins or loses it all), forward contracts offer potential benefits to both buyers and sellers. In a zero-sum game, one party wins all or loses all.
For buyers, forwards lock in prices, enabling them to predict and control variable costs of commodities. They can hedge against volatility in the currency exchange rate by locking in the rate using a forward contract.
For sellers, forward contracts enable them to project cash flow by knowing the value of a future asset when the forward contract is struck. Forward contracts obligate buyers to take possession of the commodity upon the delivery date, so sellers also have certainty of who they are delivering their commodities to and by when. They can use this information for business planning and management purposes and reduce their risk.
Lastly, because forward contracts are unregulated, they are also private. Buyers and sellers have the freedom to strike whatever price they deem is fair and acceptable but have no obligation to disclose that price to anyone else.
Forward Contract Example
Old MacDonald had a farm, and on that farm, he grew corn – a lot of corn. This year, he expects to produce 500 bushels of corn. He can sell the corn at the price-per-bushel that’s available at harvest time – or he can lock in a price now.
The Crunchy Breakfast Cereal Company needs plenty of corn to manufacture their cornflakes. They send a representative around to Old MacDonald’s farm and offer him a fixed price to be paid upon delivery of 500 bushels of corn at harvest.
Old MacDonald is happy to have the forward contract and will receive the delivery price if he can deliver 500 bushels of corn by a specific date. Based upon the expected delivery price, if he's able to produce the 500 bushels of corn, he can plan this year’s farm revenues and next year’s expenses.
The Crunchy Breakfast Cereal Company is happy with the forward contract, too. Because they have a forward contract, they can control variable costs (such as the cost of corn) to make their breakfast cereal. Knowing the cost of corn in advance enables them to keep prices steady for the consumer. They risk overpaying Old MacDonald for his corn, but it's a risk they’re willing to take to hold costs steady and retain market share for their cornflakes.
Forward Contracts vs. Futures Contracts
Forward contracts and futures contracts are similar in that both are derivative instruments. A derivative is a contract that has value based on the value of another, underlying asset. But they differ in several ways.
Attributes of Forward Contracts
Forward contracts are unregulated derivative instruments. Banks often execute forward contracts on behalf of their clients (especially currency forward contracts) but other contracts may be drawn up privately.
Attributes of Futures Contracts
The Commodities Futures Trading Commission regulates futures contracts in the United States, and trades must be executed on the floor of a registered commodities exchange. Firms and individuals who provide advice or trade futures must be registered with the National Futures Association. To place an order for futures, clients register with the broker of their choice (who can execute trades on their behalf).
The futures exchange also acts as a clearinghouse and counterparty for both the buyer and the seller. That is, both buyer and seller are actually trading with the exchange, rather than directly with each other. This reduces the risk of counterparty default. Because there is no central clearinghouse for forward contracts, there is also a higher default risk.
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How Are Forward Contracts Related to Cash Flow Hedges?
Cash flow hedges are used by companies to limit the risk of changes in cash flow due to a variable asset. Forward contracts are related to cash flow hedges in that companies can use foreign currency forward contracts to hedge against changes in the currency exchange rates of an existing asset or liability. The forward contract locks in the exchange rate.
Can Forward Contracts Be Cancelled?
Forward contracts cannot be canceled. Instead, a second contract is created that takes the exact opposite position and expires on the same date, nullifying the original forward contract.
Are Forward Contracts Regulated?
Unlike futures contracts which are regulated, forward contracts are unregulated. They are private agreements made between buyers and sellers.
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