What is a forward contract?
Looking for a forward contract definition? A forward contract is a contract between two parties that commits them to buy or sell an asset at an agreed price on a specific date in the future. This makes it a type of derivative, with the buyer taking a long position, and the seller a short position. Commodities, currencies and financial instruments can all be traded in forward contracts.
Where have you heard about forward contracts?
Businesses often use forward contracts at times of uncertainty and volatility in an attempt to lock in prices, gain control over costs and give them greater certainty. For example, there’ve been sharp currency fluctuations in the wake of the Brexit vote, and you might have read that many companies are using forward contracts to hedge their foreign exchange exposures.
You’ll probably also have heard of farmers and other commodities producers entering into forward contracts – it’s a particularly common practice in the agricultural sector, because it helps to hedge against future price fluctuations.
What you need to know about forward contracts…
So exactly what is forward contract? A forward contract is a customised private agreement between buyer and seller, in which the buyer has an obligation to purchase an asset, and the seller has an obligation to sell the asset, at a predetermined price – the forward price – on a specified future date. The forward price can be calculated from the spot price and the risk-free rate with this formula:
F = S x e^(r x t)
In the formula, F is the contract's forward price; S is the underlying asset's current spot price; and e is the irrational constant of roughly 2.718. The risk-free rate applying to the life of the forward contract is denoted by r, and the delivery date in years by t.
Forward contract terms
Forward contract terms can vary from contract to contract. Because each forward contract is different, they're not traded on exchanges but over-the-counter (OTC), so it's harder for retail investors to access them. The fact that the details of individual forward contracts are confidential, and known only to the buyer and seller, also means that there’s no exact picture of the size of the forward contract market. While speculators sometimes use forward contracts, forwards are considered to be especially suitable for hedging because of their non-standardised features.
Settlement takes place at the end of a forward contract, and it can be done on a cash or delivery basis:
- A contract made on a delivery basis will require the seller to supply the asset to the buyer on the settlement date, in return for the agreed cash payment from the buyer
- If the contract is cash settled, a payment is made on the settlement date for the value of the forward contract, and the asset is never delivered to the buyer. The amount of the cash settlement is based on the difference between the current market price and the agreed contract price. If the market and contract prices are identical on the date of settlement, no money changes hands and the contract is closed
As no clearing house is involved in a forward contract to guarantee performance, there’s an element of risk that one of the parties could default. A premium for this additional credit risk is therefore often included in forward-contract prices.
Examples of forward contract hedging
So, how does forward contract hedging work in practice? Let’s consider a couple of examples. First, imagine you’re a farmer and you’re selling wheat at the current rate of £3 a bushel, but you reckon that wheat prices will fall in the months ahead. In that case you can enter into a forward contract with a bakery chain to sell them a specific amount of wheat at £3 a bushel in three months’ time. If the price of wheat falls under £3 a bushel, you’re protected because you’ll get what the contract entitles you to. But if wheat prices actually rise, you’ll miss out on the profit because – again – you’ll only get the price stipulated in the contract.
Now imagine you’re a British citizen looking to invest in a property in the Eurozone. The property costs €1 million. Before the Brexit vote, this might have set you back around £715,000. But exchange rates can be very volatile, and since sterling’s post-referendum plunge you might have to fork out something like £940,000 for the very same property. And if the sterling/euro rate reaches parity, that €1 million property would cost you £1 million.
So, if you know that you’re going to need to pay someone €1 million in the future, but you suspect that the exchange rate will move against you between now and then, a forward contract could be the answer. All leading currency brokers offer forward contracts that enable individuals to lock in at today's exchange rate, for delivery at a future date. So forward contract hedging can offer peace of mind in the currency markets – but do remember that you won’t benefit at all if the exchange rate moves in your favour.
Futures vs forwards
Forward contracts and futures contracts are closely related, as they both enable people to buy or sell assets at a specified price at an agreed time, but there are some key differences between the two.
Firstly, futures contracts are highly standardised to enable trading on a futures exchange, whereas as we’ve seen, forward contracts are private agreements whose terms are customised to suit both parties. They’re not traded on exchanges.
The second big difference concerns counterparty risk – the risk that one of the parties to a contract will renege on its terms. With futures contracts, the exchange clearing house acts as counterparty to both sides in the agreement. All futures positions are marked-to-market on a daily basis, meaning that both parties must have the money to ride out price fluctuations for the duration of the contract.
Forwards, on the other hand, don’t have interim partial settlements or margin requirements. As they’re only settled at the time of delivery, any profit or loss on a forward contract is only realised on settlement. This means that credit exposure can keep rising throughout the life of the contract – making forwards a riskier proposition than futures.
Finally, because futures contracts are often used by speculators betting on an asset's price’s movement, they tend to be closed out before maturity, and delivery usually never takes place. Forward contracts, on the other hand, are mainly used by hedgers who are seeking to protect themselves against price volatility, so delivery of the asset or cash settlement usually does take place. That’s another big difference between futures vs forwards.
Find out more about forward contracts…
If you want to explore ‘what is forward contract’ further, our comprehensive glossary has definitions for many related terms such as risk, hedge, spot and foreign exchange. For more on the topic of futures vs forwards, why not take a look at our definition of futures contract.
Study.com has a useful introductory video that explains ‘ what is forward contract’. You can view it by following this link.
Finally, this two-minute YouTube video by Olympia Trust Foreign Exchange explains how foreign exchange forward contracts work.