What are forward contracts? Definition, features, and how to use


In times of economic uncertainty or if you wish to exercise caution to safeguard against potential financial risks, one alternative is to consider forward contracts (customisable derivative contracts), whether you are an individual or a company.

But what exactly are these types of contracts? What are their pros and cons? Is any specific documentation necessary?

Continue reading to discover this and more, enabling you to make an informed decision about whether this is the appropriate alternative for your next investment.

What are forward contracts?

You may have already heard of derivatives. Forward contracts, also known as forwards, are contracts between two parties. The two parties plan to buy or sell an asset at a specific price on a future date.

In practical terms, one party commits to buying, and the other commits to selling, at a future date, an agreed-upon amount or quantity of the asset underlying the contract, but at a price set in the present, in advance.

The assets exchanged in forward contracts can be any relevant assets whose prices fluctuate over time, and they are used to mitigate market risks. Forwards are OTC products and are customisable.

Features of forward contracts

  • A type of derivative. Forward contracts are a type of derivative, that is, a financial product whose value depends on the evolution of the price of another asset, which is called the underlying asset. Among them are certificates, CFD, futures, options, swaps, warrants and, of course, forward contracts.
  • Agreement between two parties. This type of contract is not signed unilaterally but bilaterally. This means that it will be between two companies, two financial institutions, a financial institution and a company, or between two individuals.
  • Place of transaction. Forward contracts are not traded on the stock exchange, but in over-the-counter markets called OTC (Over the Counter). Many online brokers offer forwards.
  • Hedging as a goal. That's right, one of the objectives of having a forward contract is to protect the underlying asset of the contract from depreciation or appreciation (depending on strategy).
  • Who uses forwards? They are recommended for those who want to anticipate and cover possible financial risks that may occur in the future. But, above all, to natural or legal persons who must make future payments or collections in dollars or another foreign currency. In addition, while they are contracts that are used to cover market risks, as we mentioned earlier, they are also interesting for investors willing to take risks in exchange for a probable gain.
  • They are customisable. This means that if both parties agree, they can modify the expiration date, the agreed price or the delivery method, the amount involved and also the selling or buying party. However, they are not transferable if they include currencies, and you must wait until maturity to be able to settle through the delivery of the agreed currencies.

Forward contracts versus futures contracts, what's the difference?


Forward contracts and futures contracts are both types of financial derivatives used for hedging and speculation, but they have several key differences.

Forward contracts

  • Private agreements between two parties and are not traded on an exchange. As a result, the terms of the contract can be customised to fit the needs of the two parties involved.
  • Since these contracts are private and not traded on an exchange, there is a higher risk of default from the counterparty. This is known as counterparty risk.
  • Being private contracts, they are subject to less regulation. This can lead to a lack of transparency and higher risk.
  • Settlement occurs at the end of the contract term. There is no daily settlement, and the gain or loss on the contract is realised only at the time of settlement.
  • Primarily used for hedging purposes, particularly by companies looking to lock in prices for commodities or currencies.
  • Usually do not require margins.

Futures contracts

  • Standardised contracts traded on an exchange. The terms of the contract, including the quantity, quality, and delivery date of the underlying asset, are standardised (not customisable like forwards).
  • Because they are traded on an exchange, the risk of one party defaulting is minimised. Exchanges typically require a clearinghouse that acts as the counterparty to every trade, providing a guarantee that the terms of the contract will be fulfilled.
  • Regulated by financial authorities, providing a more secure and transparent trading environment.
  • Typically settled daily, with the accounts of the parties involved being adjusted to reflect gains or losses (known as marking to market).
  • Often used for both hedging and speculation. Participants range from individual traders to large institutions.
  • Require an initial margin and have maintenance margins. This can provide a higher degree of leverage.

Types of forward contracts

There are multiple types of forward contracts:

  1. Commodity forwards: These are agreements to buy or sell a specific quantity of a commodity (like oil, gold, or agricultural products) at a predetermined price on a future date. They are widely used in the commodities markets by producers, consumers, and speculators.
  2. Currency forwards: Often used in international trade and finance, these contracts lock in an exchange rate for a specific currency amount to be exchanged on a future date. They help businesses and investors manage currency risk arising from fluctuations in exchange rates.
  3. Interest rate forwards: These forward contracts are agreements to borrow or lend a certain amount of money at a predetermined interest rate on a future date. They are used by financial institutions and companies to hedge against interest rate fluctuations.
  4. Equity forwards: These contracts involve the agreement to buy or sell a specific number of equity shares or a stock index at a set price on a specified future date. Investors and traders use them to hedge or speculate on the movement of stock prices.
  5. Energy forwards: Similar to commodity forwards but specifically for energy products like oil, natural gas, and electricity. These are crucial for energy companies and heavy consumers of energy to manage the risk of price fluctuations.

The settlement, what is it and how does it work?

Settlement refers to the process of finalising the transaction as per the terms agreed upon when the contract was initiated. This process is distinct for forward contracts, and here's how it typically works:

  • The settlement of a forward contract occurs on a specific date agreed upon at the contract's initiation. This date is known as the settlement date or delivery date.
  • Physical settlement: In some cases, especially when dealing with commodities, the settlement involves the actual physical delivery of the underlying asset. For example, if the forward contract is for a commodity like wheat or oil, the seller delivers the agreed quantity of the commodity to the buyer on the settlement date.
  • Cash settlement: More commonly in the case of financial instruments like currencies or interest rates, settlement is done in cash. This means that the difference between the market price of the underlying asset at the time of settlement and the price agreed upon in the forward contract is exchanged. If the market price is higher than the contract price, the seller pays the difference to the buyer, and vice versa.

Forward contracts examples

Here are some examples of how forwards are used:

Commodity forward for a coffee shop owner:

  • A coffee shop owner expects to need 1000 kilograms of coffee beans in six months. The owner enters into a forward contract with a supplier to buy 1000 kilograms of coffee beans at a fixed price in six months. Regardless of market price fluctuations, the owner is guaranteed to get the coffee beans at the agreed price, providing cost certainty.

Interest rate forward for a mortgage applicant:

  • A prospective homeowner plans to take out a mortgage in six months. Interest rates are expected to rise, which would increase the cost of the mortgage. The homeowner enters into an interest rate forward contract that locks in the current lower interest rate for their mortgage starting in six months. The homeowner secures a mortgage at a favourable interest rate, avoiding the cost increase due to rising rates.

Pros and cons

Pros

  • Forwards are excellent tools for hedging against the risk of adverse price movements in various markets, such as commodities, currencies, and interest rates.
  • Forward contracts can be tailored to the specific needs of the contracting parties, including the quantity, quality, delivery time, and price of the underlying asset.
  • Typically, there are no upfront costs for entering into a forward contract
  • By locking in a price or rate, participants can avoid the risk of market fluctuations

Cons

  • There is a risk that the other party may default or fail to honor the contract
  • Forward contracts are not traded on an exchange, which means they can lack liquidity and might be difficult to cancel or modify without the agreement of both parties.
  • If market prices move favourably after the contract is entered into, participants may miss out on potential gains, as they are locked into the contract terms.
  • Since the settlement occurs at the end of the contract term, there’s a risk associated with the time gap between entering the contract and its settlement

3 UK brokers to trade forward contracts

Here are the best UK brokers to consider if you want to trade forward contracts:

Learn more about derivatives

Summary

Forward contracts are financial tools valuable for hedging and strategic planning. They enable parties to set future prices or rates in various markets, providing protection against price fluctuations. Customisation is a key feature, allowing contracts to be specifically tailored.

However, they come with risks like counterparty default and lack of liquidity. Also, participants might miss out on beneficial market changes after entering a contract. While forwards are effective in managing certain risks, they require careful consideration due to challenges in regulatory oversight and market fluidity. They represent a balance between security against market changes and potential challenges in adaptability and fulfilment risk.

FAQs

Who uses forward contracts?

Forward contracts are used by businesses, investors, and traders. Businesses use them to hedge against price changes in commodities or currencies, while investors and traders might use them for speculation or risk management.

What are the advantages of using forward contracts?

Advantages include risk hedging against price volatility, contract customisation, and no upfront costs. They provide certainty in pricing for future transactions.

Can forward contracts be cancelled?

Forward contracts are not easily cancellable as they are private agreements. Any cancellation would require mutual consent of both parties, and may incur costs.

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