Forward Contract

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A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement.

Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to canceling the contract, or you must find a third party to take an offsetting position in. This also increases credit risk for both parties.

What are the uses of forward contracts?

Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset derivative.

Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.

How do forward contracts work?

Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset.

If the contract is cash settledpot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset.

A quick example would help illustrate the mechanics of a cash settled forward contract. On January 1, 2009 Company X agrees to buy from Company Y 100 pounds of coffee on April 1, 2009 at a price of $5.00 per pound. If on April 1, 2009 the spot price (also known as the market price) of coffee is greater than $5.00, at say $6.00 a pound, the buyer has gained. Rather than having to pay $6.00 a pound for coffee, it only needs to pay $5.00. However, the buyer's gain is the seller's loss. The seller must now sell 100 pounds of coffee at only $5.00 per pound when it could sell it in the open market for $6.00 per pound. Rather than the buyer giving the seller $500 for 100 pounds of coffee as he would for physical delivery, the seller simply pays the buyer $100. The $100 is the cash difference between the agreed upon price and the current spot price, or ($6.00-$5.00)*100.

Risks of forward contracts

Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaults between the initial agreement date and delivery date, you may have a loss. However, two conditions must apply before a party faces a loss:

  1. The spot price moves in favor of the party, entitling it to compensation by the counterparty, and
  2. the counterparty defaults and is unable to pay the cash difference or deliver the asset.
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