What Is a Forward Contract With Example?

Forward contracts are private agreements between two parties that define the terms of a sale or purchase. They are generally used by large businesses and institutional investors. For example, a major coffee company can use a forward contract to lock in the price of their beans and avoid the risk of sudden changes in bean prices for their customers. It can also help them better project their profit from sales.

Forward contracts can be tailored to suit each trade. They can be cash-based, delivery-based or both. These types of contracts differ in many ways, including the underlying assets involved and the method of settlement.

The underlying asset of a forward contract is a commodity or security. Some of these are oil, currency exchanges, and agricultural products. A common type of underlying asset is wheat. This type of contract is commonly used by corporate investors to hedge against currency exchange rates, raw material costs, and market volatility.

A typical forward contract involves the buyer, or seller, entering a long or short position. In the case of a forward with a price, the buyer agrees to pay a certain price for the asset at a specified future date, while the seller takes a short position.

Unlike futures contracts, which can be traded on a stock exchange, forwards are not standardized. They can vary between different trades and are not publicly traded. Moreover, they are often referred to as “over the counter” deals, meaning that no one is obligated to buy or sell them, and they are not regulated.

One of the key benefits of forwards is their flexibility. Because they are not regulated, there are no rules on what type of underlying asset can be used. Therefore, the buyer can opt to buy an asset at a lower rate, while the seller can choose to sell it at a higher rate.

Similarly, the seller can choose to settle the contract on cash, delivery, or both. If the buyer is in a short position, they can opt for a cash settlement. However, if the buyer is in a long position, they can settle the contract on delivery.

Futures contracts are more liquid and are more suited to trading by speculators. While forwards are a good option for hedging against volatility, they are not as easy to access as futures. Also, futures are more standardized, whereas forwards are less standardized and can be tailored to specific requirements.

In addition to being more customizable, futures contracts are more accessible to everyday investors, as they can be settled over a wide range of dates. By contrast, forwards can last for years or even decades.

Although a forward contract is more speculative than futures, it can also be used to diversify your portfolio. Since it is based on an underlying asset, it is less risky. On the other hand, the risks involved are higher with futures.

As a result, forward contracts are typically used by large businesses or institutions to hedge against volatility and manage price volatility. By doing so, they can protect their operations from the rising cost of raw materials and currency exchange rates.