Forward

What is a Forward (Forward Contract)?

A forward (forward contract) is an off-the-run financial contract agreed by two parties to purchase or sell a good on a set future date and price at a predetermined level. Unlike futures contracts that are standardized, forward contracts are negotiated in private and traded over-the-counter (OTC), providing some flexibility in the transaction terms.

Forwards: Key Features

• Contract Customization: The forward contracts are adaptable to the specific needs of the buyer and seller, including contract size, maturity date, and underlying asset.
• Over-the-counter Trading: The contracts are traded in the over-the-counter market and not on organized exchanges; thus, they entail counterparty risk since there is no clearinghouse to ensure the security of the trade.
• Settlement: Settlement occurs on the maturity date of the contract, either in the form of delivery of the asset or cash payment as per agreement.
• No Initial Margin: Forward contracts never typically require an initial margin or a daily settlement adjustment to market price, unlike futures.

How Forward Contracts Work

1. There are two parties that agree on the terms of the contract, such as the asset, quantity, price, and settlement date.
2. No payment is made in cash when entering the contract.
3. The buyer buys the asset on the settlement date for the price agreed, regardless of the market price prevailing then.

Using Forward Contracts

Forward contracts, like other derivatives (see derivatives), provide market participants with greater options and thus greater flexibility in financial and business transactions:

• Hedging: Forward contracts are employed by investors and firms to protect themselves against fluctuations in market prices. For example, an airline firm can agree to forward jet fuel prices and protect itself from the risk of volatility and need to re-price air travel costs.
• Speculation: Forward contracts can be utilized by traders to bet on changes in the future price of an asset such as a commodity, a fiat currency, a cryptocurrency, or stocks in a company.
• Forex (FX) Risk Management: Companies trading internationally utilize forward contracts as a hedge to reverse exchange rate fluctuations.

Risks and Considerations

Aside from the benefits, the use of forwards has inherent risks:

• Counterparty risk: Because forward contracts are privately negotiated, there is a risk of default by one party.
• Liquidity concerns: Forward contracts are less liquid than futures contracts because they are not standardized or listed on an exchange.
• No mark-to-market: The value of the contract is only materialized at settlement, which can lead to gigantic financial surprises.

Comparison: Forwards vs. Futures

Conclusion

Forwards offer beneficial flexibility in hedging trades and market speculation, but conversely, they involve risks due to their over-the-counter nature. Businesses and investors must understand the benefits and potential risks of forward contracts in order to efficiently handle financial risk.